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CHAPTER 2

THE ASSET ALLOCATION DECISION

Answers to Questions

1. In answering this question, one assumes that the young person has a steady job, adequate
insurance coverage, and sufficient cash reserves. The young individual is in the
accumulation phase of the investment life cycle. During this phase, an individual should
consider moderately high-risk investments, such as common stocks, because he/she has a
long investment horizon and earnings ability.

2. In answering this question, one assumes that the 63-year-old individual has adequate
insurance coverage and a cash reserve. Depending on her income from social security,
she may need some current income from her retirement portfolio to meet living expenses.
At the same time, she will need to protect herself against inflation. Removing all her
money from her company’s retirement plan and investing it in money market funds
would satisfy the investor’s short-term current income needs. Investing in long-term
investments, such as common stock mutual funds, would provide the investor with
needed inflation protection.

3. Typically investment strategies change during an individual’s lifetime. In the

accumulating phase, the individual is accumulating net worth to satisfy short-term needs
(e.g., house and car purchases) and long-term goals (e.g., retirement and children's
college needs). In this phase, the individual is willing to invest in moderately high-risk
investments in order to achieve above-average rates of return.

In the consolidating phase, an investor has paid off many outstanding debts and typically
has earnings that exceed expenses. In this phase, the investor is becoming more
concerned with long-term needs of retirement or estate planning. Although the investor is
willing to accept moderate portfolio risk, he/she is not willing to jeopardize the “nest
egg.”

In the spending phase, the typical investor is retired or semi-retired. This investor wishes
to protect the nominal value of his/her savings, but at the same time must make some
investments for inflation protection.

The gifting phase is often concurrent with the spending phase. The individual believes
that the portfolio will provide sufficient income to meet expenses, plus a reserve for
uncertainties. If an investor believes there are excess amounts available in the portfolio,
he/she may decide to make “gifts” to family or friends, institute charitable trusts, or
establish trusts to minimize estate taxes.

4. A policy statement is important for both the investor and the investment advisor. A policy
statement assists the investor in establishing realistic investment goals, as well as
providing a benchmark by which a portfolio manager’s performance may be measured.
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5. Student Exercise

6. The 45-year old uncle and 35-year old sister differ in terms of time horizon. However,
each has some time before retirement (20 versus 30 years). Each should have a
substantial proportion of his/her portfolio invested in equities, with the 35-year old sister
possibly having more equity investments in small firms or international firms (i.e., can
tolerate greater portfolio risk). These investors could also differ in current liquidity needs
(such as children, education expenses, etc.), tax concerns, and/or other unique needs or
preferences.

7. Before constructing an investment policy statement, the financial planner needs to clarify
the client’s investment objectives (e.g. capital preservation, capital appreciation, current
income or total return) and constraints (e.g. liquidity needs, time horizon, tax factors,
legal and regulatory constraints, and unique needs and preferences).

8. Student Exercise

9. CFA Examination III (1993)

9(a). At this point we know (or can reasonably infer) that Mr. Franklin is:
 unmarried (a recent widower)
 childless
 70 years of age
 in good health
 possessed of a large amount of (relatively) liquid wealth intending to leave his estate
to a tax-exempt medical research foundation, to whom he is also giving a large
current cash gift
 free of debt (not explicitly stated, but neither is the opposite)
 in the highest tax brackets (not explicitly stated, but apparent)
 not skilled in the management of a large investment portfolio, but also not a complete
novice since he owned significant assets of his own prior to his wife’s death
 not burdened by large or specific needs for current income
 not in need of large or specific amounts of current liquidity

Taking this knowledge into account, his Investment Policy Statement will reflect these
specifics:

Objectives:

Return Requirements: The incidental throw-off of income from Mr. Franklin’s large asset
pool should provide a more than sufficient flow of net spendable income. If not, such a
need can easily be met by minor portfolio adjustments. Thus, an inflation-adjusted
enhancement of the capital base for the benefit of the foundation will be the primary
return goal (i.e., real growth of capital). Tax minimization will be a continuing collateral
goal.

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Risk Tolerance: Account circumstances and the long-term return goal suggest that the
portfolio can take somewhat above average risk. Mr. Franklin is acquainted with the
nature of investment risk from his prior ownership of stocks and bonds, he has a still long
actuarial life expectancy and is in good current health, and his heir - the foundation,
thanks to his generosity - is already possessed of a large asset base.

Constraints:

Time Horizon: Even disregarding Mr. Franklin’s still-long actuarial life expectancy, the
horizon is long-term because the remainder of his estate, the foundation, has a virtually
perpetual life span.

Liquidity Requirement: Given what we know and the expectation of an ongoing income
stream of considerable size, no liquidity needs that would require specific funding appear
to exist.

Taxes: Mr. Franklin is no doubt in the highest tax brackets, and investment actions should
take that fact into account on a continuing basis. Appropriate tax-sheltered investment
(standing on their own merits as investments) should be considered. Tax minimization
will be a specific investment goal.

Legal and Regulatory: Investments, if under the supervision of an investment

management firm (i.e., not managed by Mr. Franklin himself) will be governed by state
law and the Prudent Person rule.

Unique Circumstances: The large asset total, the foundation as their ultimate recipient,
and the great freedom of action enjoyed in this situation (i.e., freedom from confining
considerations) are important in this situation, if not necessarily unique.

9(b). Given that stocks have provided (and are expected to continue to provide) higher risk-
adjusted returns than either bonds or cash, and considering that the return goal is for long-
term, inflation-protected growth of the capital base, stocks will be allotted the majority
position in the portfolio. This is also consistent with Mr. Franklin’s absence of either
specific current income needs (the ongoing cash flow should provide an adequate level
for current spending) or specific liquidity needs. It is likely that income will accumulate
to some extent and, if so, will automatically build a liquid emergency fund for Mr.
Franklin as time passes.

Since the inherited warehouse and the personal residence are significant (15%) real estate
assets already owned by Mr. Franklin, no further allocation to this asset class is made. It
should be noted that the warehouse is a source of cash flow, a diversifying asset and,
probably, a modest inflation hedge. For tax reasons, Mr. Franklin may wish to consider
putting some debt on this asset, freeing additional cash for alternative investment use.

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Given the long-term orientation and the above-average risk tolerance in this situation,
about 70% of total assets can be allocated to equities (including real estate) and about
30% to fixed income assets. International securities will be included in both areas,
primarily for their diversification benefits. Municipal bonds will be included in the fixed
income area to minimize income taxes. There is no need to press for yield in this
situation, nor any need to deliberately downgrade the quality of the issues utilized.
Venture capital investment can be considered, but any commitment to this (or other
“alternative” assets) should be kept small.

The following is one example of an appropriate allocation that is consistent with the
Investment Policy Statement and consistent with the historical and expected return and
other characteristics of the various available asset classes:

Current
Range (%) Target (%)

Cash/Money Market 0-5 0

U.S. Fixed Income 10 – 20 15
Non-U.S. Fixed Income 5 – 15 10
U.S. Stocks (Large Cap) 30 – 45 30
(Small Cap) 15 – 25 15
Non-U.S. Stocks 15 – 25 15
Real Estate 10 – 15 15*
Other 0–5 0
100

*Includes the Franklin residence and warehouse, which together comprise the
proportion of total assets shown.

An alternate allocation could well be weighted more heavily to U.S. fixed income
and less so to U.S. stocks, given the near equality of expected returns from those
assets as indicated in Table 4.

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CHAPTER 2

Answers to Problems

1. Most experts recommend that about 6 month’s worth of living expenses be held in cash
reserves. Although these funds are identified as “cash,” it is recommended that they be
invested in instruments that can easily be converted to cash with little chance of loss in value
(e.g., money market mutual funds, etc.).

Most experts recommend that an individual should carry life insurance equal to 7-10 times
an individual’s annual salary. An unmarried individual should have coverage equal to at least
7 times salary, whereas a married individual with two children should have more coverage
(possibly 9-10 times salary).

2. Married, filing jointly, $20,000 taxable income:

Marginal tax rate = 15%
Taxes due = $20,000 x .15 = $3,000
Average tax rate = 3,000/20,000 = 15%

Married, filing jointly, $40,000 taxable income:

Marginal tax rate = 15%
Taxes due = $40,000 x .15 = $6,000
Average tax rate = 6,000/40,000 = 15%

Married, filing jointly, $60,000 taxable income:

Marginal tax rate = 28%
Taxes due = $6,780 + .28($60,000 - $45,200)
= $6,780 + $4,144 = $10,924
Average tax rate = 10,924/60,000 = 18.21%

3. Single with $20,000 taxable income:

Marginal tax rate = 15%
Taxes due = $20,000 x .15 = $3,000
Average tax rate = 3,000/20,000 = 15%

Single with $40,000 taxable income:

Marginal tax rate = 28%
Taxes due = $4,057.50 + .28($40,000 - $27,050)
= $4,057.50 + $3,626 = $7,683.50
Average tax rate = 7,683.50/40,000 = 19.21%

Single with $60,000 taxable income:

Marginal tax rate = 28%
Taxes due = $4,057.50 + .28($60,000 - $27,050)
= $4,057.50 + $9,226 = $13,283.50
Average tax rate = 13,283.50/60,000 = 22.14%
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4(a). $10,000 invested in 9 percent tax-exempt IRA (assuming annual compounding)

in 5 years: $10,000(FVIF @ 9%) = $10,000(1.5386) = $15,386

in 10 years: $10,000(FVIF @ 9%) = $10,000(2.3674) = $23,674
in 20 years: $10,000(FVIF @ 9%) = $10,000(5.6044) = $56,044

4(b). After-tax yield = Before-tax yield (1 - Tax rate)

= 9% (1 - .36)
= 5.76%

$10,000 invested at 5.76 percent (assuming annual compounding)

in 5 years: $10,000(FVIF @ 5.76%) = $13,231

in 10 years: $10,000(FVIF @ 5.76%) = $17,507
in 20 years: $10,000(FVIF @ 5.76%) = $30,650

5(a). $10,000 invested in 10 percent tax-exempt IRA (assuming annual compounding)

in 5 years: $10,000(FVIF @ 10%) = $10,000(1.6105) = $16,105

in 10 years: $10,000(FVIF @ 10%) = $10,000(2.5937) = $25,937
in 20 years: $10,000(FVIF @ 10%) = $10,000(6.7275) = $67,275

5(b). After-tax yield = Before-tax yield (1 - Tax rate)

= 10% (1 - .15)
= 8.50%

$10,000 invested at 8.50 percent (assuming annual compounding)

in 5 years: $10,000(FVIF @ 8.50%) = $15,037

in 10 years: $10,000(FVIF @ 8.50%) = $22,610
in 20 years: $10,000(FVIF @ 8.50%) = $51,120

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