Constructing a Portfolio Using an Asset Allocation Scheme: An investor's personal characteristics are important inputs to an investment policy

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Constructing a Portfolio Using an Asset Allocation Scheme:

An investor's personal characteristics are important inputs to an investment policy. There are five factors to consider: (1) level and stability of income, (2) family factors, (3) net worth, (4) investor experience and age, and (5) investor disposition toward risk. The first factor determines whether or not the investor wants high dividend paying stocks or stocks with good capital appreciation potential. The next two reflect to what extent the investor wants to take risk. For example, a person with a family and a moderate net worth might take less risk that an unmarried person with a sizable net worth. The investor's experience and age also determine whether or not the investor wishes to take high or low risks and whether or not the person seeks high current income or high capital appreciation potential. Needless to say, the investor's disposition toward risk ultimately determines the type of portfolio he or she will choose. Given an acceptable level of risk, the investor should select that portfolio offering the highest expected return in a fashion consistent with the factors addressed above.

 

Portfolio objectives can fall into five major categories: current income, capital preservation, capital growth, tax considerations, and risk. An investor's portfolio strategy will be guided by his or her particular portfolio objectives, which are in turn based on his or her needs and attitudes toward risk. Normally, a person with current needs and a motive for capital preservation would choose low-beta (low-risk) securities. An investor whose main objective is capital growth would make investments with higher risk, such as growth stocks, options, commodities and financial futures, gold, real estate, and other more speculative investments. High-income investors generally wish to defer taxes and earn investment returns in the form of capital gains. This implies a strategy of higher-risk investments and a longer holding period. All investors must consider the risk-return trade-off when making investment decisions. Ultimately, the amount of risk an investor is willing to take and the risk-return trade-off will determine the kind of investment he or she will include in a portfolio.

 

An asset allocation scheme (diversification) is an investment strategy that involves dividing one's portfolio into various asset classes to preserve capital. It seeks to protect against negative developments while still taking advantage of positive developments. It is based on the belief that the total return of a portfolio is influenced more by the way investments are allocated than by the actual investments. Furthermore, researchers have found that asset allocation has a much greater impact on reducing total risk exposure than picking an investment vehicle in any single category. Clearly, asset allocation is an important aspect of portfolio management. An example of an asset allocation would be to put 30% of the portfolio in common stock, 50% in bonds, 5% in short-term securities, and 15% in real estate.

 

There are three basic approaches to asset allocation:

 

(a) Fixed weightings involve allocating a fixed percentage of the portfolio to each of the (typically three to five) asset categories. Under this approach, the weights do not change over time. Because of shifting market values, the portfolio using this approach may have to be revised annually or after major market moves in order to maintain the fixed percentage allocations.

 

(b) Flexible weightings involve periodic adjustments of the weights for each asset category based either on market analysis or technical analysis (i.e., market timing). The use of flexible weights is often called strategic asset allocation. The weights under this approach are generally changed in order to capture greater returns in a changing market.

 

(c) Tactical asset allocation is a sophisticated approach that uses stock index futures and bond futures to change a portfolio's asset allocation. When stocks seem less attractive than bonds, this strategy involves selling stock index futures and buying bond futures; and when bonds seem less attractive than stocks, the strategy results in buying stock index futures and selling bond futures. Because this approach relies on a large portfolio and the use of quantitative models for cues, it is generally only appropriate for large institutional investors rather than individual investors.

An asset allocation plan should consider the investor's investment, savings and spending patterns, the economic outlook, tax situations, return expectations, risk tolerance, and so forth. Age will also have an effect; younger investors are often willing to accept greater risk than those at or near retirement. Such plans must be formulated for the long run, stress capital preservation, and provide for periodic revision in order to maintain consistency with changing investment goals.

To decide the appropriate asset mix, investors must evaluate each asset category relative to current return, growth potential, safety, liquidity, transaction costs (brokerage fees), and potential tax savings. Frequently, mutual funds are employed to diversify within each asset category; a family of funds can be used to permit switching among categories by phone. As an alternative to building his or her own portfolio, an investor can buy shares in an asset allocation fund, a mutual fund that seeks to reduce volatility by investing in the right assets at the right time. These funds, like asset allocation schemes, emphasize diversification and perform at a relatively consistent level. They pass up the potential for spectacular gains in favor of predictability. Generally, only those with less than about $25,000 and/or limited time will find asset allocation funds most attractive. Those with between $25,000 and $100,000 to invest and adequate time can use mutual funds to workable asset allocation, and those with more than $100,000 and adequate time can justify do-it-yourself asset allocation.

Evaluating the Performance of Individual Investments:

It is important for an investor to continuously manage and control his or her portfolio to be sure that investment goals are being met. Over time, the securities in the portfolio may change their investment characteristics, thereby changing the character of the portfolio. If the portfolio performance is inconsistent with its goals, it should be adjusted and revised to remain consistent with the investor's needs. The management and control process involves assessing actual performance, comparing it to planned performance, revising and making needed adjustments, and timing these adjustments to achieve maximum benefit.

Current market information, such as share price, dividend yield, and similar return data, are critical to performance evaluation. Regularly checking this data, as well as following a company's earnings, dividend payments, and general news provide a way to monitor stock performance and decide whether the investment should be held. Changes in economic and market activity can affect the level of current income and the market value of each investment vehicle differently. For some investments, such as real estate, local economic activity is most important. Bonds may be most affected by nationwide economic conditions. Gold is most affected by international economic and political conditions. Sources of economic information include large regional banks, New York City banks, the Federal Reserve Banks, and investment services. All investments are affected by non-diversifiable risk which is tied to changes in market activity.

In evaluating the performance of his or her portfolio, an investor should compare it to some measure of general market returns. For stocks, one could use the Dow Jones Industrial Average. However, it is actually not considered the most appropriate gauge of stock price movement. Including only 30 stocks, it is not broad based. A better index is the Standard and Poor's 500 Stock Composite Index or the New York Stock Exchange Composite Index. For bonds, the Dow Jones Corporate Bond Average or data from Standard & Poor's, Mergent, and/or the Federal Reserve are appropriate. Real estate returns are more localized. Therefore, in real estate markets one would analyze local returns. This information may be available at local real estate boards and/or agencies. The investor should probably distinguish between income property and undeveloped property.

Portfolio performance is measured by calculating the holding period return (HPR) for the portfolio. This involves (1) measuring the amount invested, (2) measuring income, (3) measuring capital gain, and (4) combining these components to find the portfolio's HPR.

 

        HPR = [Current income during period + Capital gain (or loss) during period] / Beginning investment value

 

        HPR = (C + CG) / V0

where;

        Capital gain (or loss) during period = Ending investment value - Beginning investment value

       CG = Vn - V0

An investment holding is a candidate for sale when: (1) it fails to perform as expected and no major change in performance is anticipated; (2) it has met the original investment objective, and (3) the investor has better investment opportunities available for the funds.

Assessing Portfolio Performance:

The HPR formula includes both realized returns (income plus realized capital gains) and the unrealized capital gains of the portfolio. Further, portfolio additions and deletions must be time-weighted for the number of months they are in the portfolio. Unrealized capital gains are those that have not yet been received. Realized capital gains, on the other hand, are the capital gains an investor has received from sale of particular securities. An unrealized capital gain can become a capital loss when economic conditions change drastically.

Once the HPR for the portfolio is calculated, the return figure should be utilized in a risk-adjusted, market-adjusted rate of return analysis. This type of comparative study can be very useful because it provides the investor with insight into how his or her portfolio is performing relative to the stock market as a whole. Comparing the return to a broad market index does not take risk into account.

Three popular measures in assessing portfolio performance are (1) Sharpe's measure, (2) Treynor's measure, and (3) Jensen's measure.

Sharpe's measure compares a portfolio's risk premium to its standard deviation of return to assess the risk premium per unit of total risk. The formula is:

        Sharpe's measure = (Total portfolio return - Risk-free rate) / Portfolio standard deviation of return

        SM = (rp - RF) / Sp

Once calculated, Sharpe's measure can be compared to the Sharpe's measures of other portfolios or the market. If the portfolio's SM is higher, it is performing better than the other portfolio or the market.

Treynor's measure also measures the risk premium per risk unit, but uses beta rather than the standard deviation to do so. It focuses on nondiversifiable risk only and is calculated as follows:

     Treynor's measure = (Total portfolio return - Risk-free rate) / Portfolio beta

        TM = (rp - RF) / bp

Using the TM, an investor can compare her or his portfolio to the market or to another portfolio. A higher TM indicates better performance.

Jensen's measure, also called alpha, uses portfolio beta and the capital asset pricing model (CAPM) to calculate the excess return—the difference between the actual return and the required return. The excess return may be positive, negative, or zero and is calculated as follows:

        Jensen's measure = (Total portfolio return - Risk-free rate) - [Portfolio beta x (Market return - Risk-free rate)]

 

        JM = (rp - RF) - [bp x rm - RF)

Positive JM values indicate the portfolio earned more than its risk-adjusted, market-adjusted required rate of return; a JM of zero means the portfolio earned its required return; negative values mean the portfolio fell short of its required return.

Jensen's measure is similar to Treynor's measure; both focus only on nondiversifiable risk by using beta. Jensen's measure is preferred because it automatically adjusts for market return through its use of the CAPM. This eliminates the need to compute a measure for the market; no further comparison is necessary. As with the other two measures, the higher the JM value, the better the portfolio is performing.

When an investor decides to change the composition of a portfolio by selling some securities and replacing them with others, he or she is engaging in portfolio revision. Periodically, the investor must check to see if the portfolio continues to meet his or her needs. Such dynamic portfolio management requires portfolio revision.

As economic conditions and individual priorities change, an investor must revise the portfolio by reallocating and rebalancing it. As the risk-return characteristics of the securities change, the investor should eliminate issues that no longer meet his or her objectives. Also, portfolio revision may be needed to maintain an adequate amount of diversification. All these situations require managing, controlling, and possibly revising the portfolio.

Timing Transactions:

The investor can utilize to time purchases and sales by using formula plans, limit and stop-loss orders, and warehouse liquidity.

Formula Plans:

Formula plans are mechanical methods of portfolio management that try to take advantage of price changes in securities that result from cyclical price movements. Formula plans, part of a conservative strategy, are designed primarily for investors who do not wish to take excessive risk but wish to quickly and favorably adjust their portfolio in response to cyclical security price changes. The four popular formula plans are: (1) Dollar-cost averaging, (2) Constant-dollar plan, (3) Constant-ratio plan, and (4) Variable-ratio plan.

The dollar cost averaging plan involves investing a fixed dollar amount in a security at fixed time intervals. This is a passive buy-and-hold strategy in which a periodic dollar investment is held constant. If the share price increases, fewer shares are purchased. When the share price declines, more shares are purchased. The hoped-for outcome is growth in the value of the selected security.

A constant-dollar plan uses a two-part portfolio. The speculative portion is invested in securities having high promise of capital gain. The conservative portion consists of low-risk investments such as bonds or money market accounts. If the speculative portion of the portfolio rises a certain percentage or amount in value, the constant-dollar plan uses its profits to increase the conservative portion. If the speculative portion declines in value by a specified percentage or amount, funds are transferred to it from the conservative portion.

The constant-ratio plan establishes a desired fixed ratio of the speculative to the conservative portion of the portfolio. An individual rebalances the portfolio whenever the actual ratio differs from the desired ratio by a predetermined amount. With this plan, an investor must decide the appropriate target ratio of the two portions of the portfolio and how far from the target ratio the actual ratio should be permitted to stray before one rebalances the portfolio. Since one expects the speculative portion of the portfolio to increase in value more rapidly than the conservative portion, this strategy should function much like the constant-dollar plan.

The variable-ratio plan is a more aggressive strategy. The target ratio between the speculative portion and the conservative portion of the portfolio is varied by the investor and depends on the expected movement in value of the speculative securities. If the investor feels the market movement will be generally upward, he or she increases the proportion in speculative vehicles. If the feeling is bearish—a downward market—the proportion in conservative vehicles is increased. This strategy is not only the most aggressive, but also requires more effort by the investor.

Limit and stop-loss orders:

The limit orders and stop-loss orders are used to rebalance the portfolio to increase return by lowering transaction costs. The primary risk in using limit orders instead of market orders is that the order may not be executed. Stop-loss orders can be used to limit the downside loss exposure of an investment. The principal risk in using stop-loss order is whipsawing which is a situation where a stock temporarily drops in price and then bounces back upward. It is important to consider the stock's probable fluctuations as well as the need to purchase or sell the stock when choosing among market, limit, and stop-loss orders.

Warehousing Liquidity:

One recommendation for an efficient portfolio is to keep a portion of it in a low-risk, highly liquid investment to protect against total loss. The low- risk asset acts as a buffer against possible investment adversity. A second reason is for maintaining funds in a low risk asset is the possibility of future opportunities. When opportunity strikes, an investor who has extra cash available will be able to take advantage of the situation.

Two primary media for warehousing liquidity are: (1) money market deposit accounts at financial institutions, and (2) money market mutual funds. The money market accounts at savings institutions provide relatively easy access to funds and furnish returns competitive with money market mutual funds. The products offered by financial institutions are becoming more competitive with those offered by mutual funds and stock brokerage firms.

Timing Investment Sales:

The two considerations in timing investment sales are tax consequences and compatibility with investment goals. When there is a capital loss, the investor receives the benefit of a tax deduction. In particular, capital losses provide tax benefits by offsetting capital gains and thereby lowering the investor's tax liability. From the point of view of investment goals, a security should be sold if it no longer meets the needs of the portfolio's owner. For example, if a particular security increases the risk of the portfolio to an extent that it is undesirable, that security should be sold in the marketplace. Although taxes are important, one should not forget that the dual concepts of risk and return remain the overriding concerns in the portfolio management and administration process.

Briefly describe the three measures of in assessing portfolio performance and explain how they are used.

What are "formula plans"? Define each using examples where necessary.