. 149
( 193 .)


Table 17.4 presents a matrix of constraints for various investors. As you would expect, liquid-
ity and tax constraints for individuals are variable because of wealth and age differentials.
A particular constraint for mutual funds arises from investor response to the fund perfor-
mance. When a mutual fund earns an unsatisfactory rate of return, investors often redeem their
shares”they withdraw money from the fund. The mutual fund then contracts. The reverse
happens when a mutual fund earns an unusually high return: It can become popular with in-
vestors overnight, and its asset base will grow dramatically.
Pension funds are heavily regulated by the Employee Retirement Income Security Act of
1974 (ERISA). This law revolutionized savings for retirement in the United States and re-
mains a major piece of social legislation. Thus, for pension funds, regulatory constraints are
relatively important. Also, mature pension funds are required to pay out more than young
funds and hence need more liquidity.

Type of Investor Liquidity Horizon Regulatory Taxes
TA B L E 17.4
Individuals and personal trusts Variable Life cycle Prudent Variable
Matrix of constraints
investor laws
(for trusts)
Mutual funds Low Short Little None
Pension funds Young, low; Long ERISA None
mature, high
Endowment funds Little Long Little None
Life insurance companies Low Long Complex Yes
Non“life insurance companies High Short Little Yes
Banks Low Short Changing Yes
Bodie’Kane’Marcus: VI. Active Investment 17. Investors and the © The McGraw’Hill
Essentials of Investments, Management Investment Process Companies, 2003
Fifth Edition

17 Investors and the Investment Process

Endowment funds, on the other hand, usually do not need to liquidate assets, or even use
dividend income, to finance payouts. Contributions are expected to exceed payouts and in-
crease the real value of the endowment fund, so liquidity is not an overriding concern.
Life insurance companies are subject to complex regulation. The corporate tax rate, which
today is 35% for large firms, also applies to insurance company investment income, so taxes
are an important concern.
Property and casualty insurance, like term life insurance, is written on a short-term basis.
Most policies must be renewed annually, which means property and casualty insurance com-
panies are subject to short-term horizon constraints.
The short horizon constraint for banks comes from the interest rate risk component of the
interest rate spread (i.e., the risk of interest rate increases that banks face when financing long-
term assets with short-term liabilities).

2. a. Think about the financial circumstances of your closest relative in your parents™ Concept
generation (for example, your parents™ household if you are fortunate enough
to have them around). Write down the objectives and constraints for their in-
vestment decisions.
b. Now consider the financial situation of your closest friend or relative who is in
his or her 30s. Write down the objectives and constraints that would fit his or
her investment decision.
c. How much of the difference between the two statements is due to the age of
the investors?

Once objectives and constraints are determined, an investment policy that suits the investor
can be formulated. That policy must reflect an appropriate risk-return profile as well as needs
for liquidity, income generation, and tax positioning. For example, the most important portfo-
lio decision an investor makes is the proportion of the total investment fund allocated to risky
as opposed to safe assets such as money market securities, usually called cash equivalents or
simply cash. This choice is the most fundamental means of controlling investment risk.
It follows that the first decision an investor must make is the asset allocation decision. As-
set allocation refers to the allocation of the portfolio across major asset categories such as:
1. Money market assets (cash equivalents).
2. Fixed-income securities (primarily bonds).
3. Stocks.
4. Non-U.S. stocks and bonds.
5. Real estate.
6. Precious metals and other commodities.
Only after the broad asset classes to be held in the portfolio are determined can one sensibly
choose the specific securities to purchase.
Investors who have relatively high degrees of risk tolerance will choose asset allocations
more concentrated in higher-risk investment classes, such as equity, to obtain higher expected
rates of return. More conservative investors will choose asset allocations with a greater weight
in bonds and cash equivalents. The nearby box about Vanguard™s asset allocation recommen-
dations illustrates this principle.
Bodie’Kane’Marcus: VI. Active Investment 17. Investors and the © The McGraw’Hill
Essentials of Investments, Management Investment Process Companies, 2003
Fifth Edition

Asset Allocation for Strength and Balance
There is one decision about your investments that will THE LIFE CYCLE APPROACH
have more impact on your returns than any other: the
In your early years, your goal is to accumulate capital
allocation of your assets among stocks, bonds, and
for retirement. Later, conserving and spending capital
cash reserves.
take precedence. Logically, your investment strategy
Far more than any particular mutual funds you may
should be tailored to these life stages.
select, your portfolio™s asset allocation will govern not
When you are in your 20s, 30s, and 40s, emphasize
only the long-term returns you may receive, but the
stocks for their potentially higher long-term returns. You
level of short-term risk you will assume, too. A portfolio
have the time to recover from spasmodic short-term
of stock funds should provide a higher total return over
declines that grip equity markets with varying degrees
time than one that concentrates on bond or money
of severity. A portfolio mix of 65“75% stocks and
market funds. However, the latter portfolio offers a
25“35% bonds and money market investments would
higher degree of stability plus the comfort of regular in-
seem reasonable. As you move into your 50s, reduce
come. A balanced approach has characteristics of both
risk and increase income by trimming stocks (per-
portfolios, plus the benefit of diversification across asset
haps to 50%) and raising bond and money market
classes. Drawing on these strengths, a balanced port-
folio is well suited to withstand the financial markets™
Once you retire, your emphasis shifts to receiving
ups and downs.
income. The majority (some 60%) of your portfolio
should be allocated to bonds and money market funds.
As an inflation hedge, maintain a significant stock po-
sition (40% is a good starting point), particularly early in
your retirement years.
Whichever approach you choose will require fortitude
to make necessary rebalancing decisions. Moving as-
Bonds sets from high-performing funds to those that may be
lagging (on a relative basis) is not easy”but it is at the
heart of a balanced investment strategy.
Money markets
15% 15%
10% SOURCE: Abridged from “Asset Allocation for Strength and Balance,”
In the Vanguard, Summer 1993. The Vanguard Group, Inc. Reprinted
30s 40s 50s 60s
with permission.

Top-Down Policies for Institutional Investors
Individual investors need not concern themselves with organizational efficiency. But profes-
sional investors with large amounts to invest must structure asset allocation activities to de-
centralize some of the decision making.
A common feature of large organizations is the investment committee and the asset uni-
verse. The investment committee includes top management officers, senior portfolio man-
agers, and senior security analysts. The committee determines investment policies and verifies
that portfolio managers and security analysts are operating within the bounds of specified poli-
cies. A major responsibility of the investment committee is to translate the objectives and con-
straints of the company into an asset universe, an approved list of assets for each of the
asset universe
company™s portfolios.
Approved list of assets
Thus, the investment committee has responsibility for broad asset allocation. While the in-
in which a portfolio
vestment manager might have some leeway to tilt the portfolio toward or away from one or
manager may invest.
another asset class, the investment committee establishes the benchmark allocation that
largely determines the risk characteristics of the portfolio. The task of choosing specific secu-
rities from the approved universe is more fully delegated to the investment manager.
Bodie’Kane’Marcus: VI. Active Investment 17. Investors and the © The McGraw’Hill
Essentials of Investments, Management Investment Process Companies, 2003
Fifth Edition

17 Investors and the Investment Process

Figure 17.1 illustrates the stages of the portfolio choice process for Palatial Investments, a
hypothetical firm that invests internationally. The first two stages are asset allocation choices.
The broadest choice is in the weighting of the portfolio between U.S. and Japanese securities.
Palatial has chosen a weight of 75% in the United States and 25% in Japan. The allocation of
the portfolio across asset classes may now be determined. For example, 15% of the U.S. port-
folio is invested in cash equivalents, 40% in fixed income, and 45% in equity. The asset-class
weights are, in general, a policy decision of the investment committee, although the invest-
ment manager might have some authority to alter the asset allocation to limited degrees based

Overall portfolio

75% 25%
U.S. Japan

15% 45% 60% 40%
Cash Fixed income Stocks Fixed income Stocks

100% 60% 40% 45% 35% 20% 100% 50% 50%

Treasury Treasury AT&T IBM GM ExxonMobil Bank of Japan Sumimoto Mitsubishi
bills bonds bonds 1-year notes Chemical
11.25% 18% 12% 15.19% 11.81% 6.75% 15% 5% 5%

F I G U R E 17.1
Asset allocation and security selection for Palatial Investments

Asset Allocation
The EfficientFrontier.com website contains access to an online journal that features the
entertaining writing of William J. Bernstein. His article “The Online Asset Allocator: What
the Investment Industry Doesn™t Want You to Know” discusses some important ideas re-
lated to investment success. Go to http://www.efficientfrontier.com/aa/index.shtml to read
the article. Then, answer the following questions:
1. What is it that the investment industry doesn™t want you to know?
2. What is the central conclusion of the article?
3. What type of investment (active or passive) policy does it suggest?
Bodie’Kane’Marcus: VI. Active Investment 17. Investors and the © The McGraw’Hill
Essentials of Investments, Management Investment Process Companies, 2003
Fifth Edition

614 Part SIX Active Investment Management

on her expectations concerning the investment performance of various asset classes. Finally,
security selection within each country is determined by the portfolio manager from the
approved universe. For example, 45% of funds held in the U.S. equity market will be placed
in IBM, 35% in GM, and 20% in ExxonMobil. (We show only three securities in the figure
because of space limitations. Obviously a $1 billion fund will hold securities of many more
These ever-finer decisions determine the proportion of each individual security in the over-
all portfolio. As an example, consider the determination of the proportion of Palatial™s port-
folio invested in ExxonMobil, 6.75%. This fraction results from the following decisions. First,
the United States receives a weight of 75% of the overall portfolio, and equities comprise 45%
of the U.S. component of the portfolio. These are asset allocation choices. ExxonMobil com-
prises 20% of the U.S. equity component of the portfolio. This is a security selection choice.
Therefore, ExxonMobil™s weight in the overall portfolio is 0.75 0.45 0.20 .0675, or
6.75%. If the entire portfolio is $1 billion, $67,500,000 will be invested in ExxonMobil. If
ExxonMobil is selling for $60 a share, 1,125,000 shares must be purchased. The bottom line


. 149
( 193 .)