When the principles of portfolio management are discussed, it is useful to distinguish among seven classes of investors:

To some extent, most institutional investors seek to match the risk-and-return characteristics of their investment portfolios to the characteristics of their liabilities.

The process of asset allocation consists of the following steps:

People living on money-fixed incomes are vulnerable to inflation risk and may want to hedge against it. The effectiveness of an asset as an inflation hedge is related to its correlation with unanticipated inflation.

For investors who must pay taxes on their investment income, the process of asset allocation is complicated by the fact that they pay income taxes only on certain kinds of investment income. Interest income on munis is exempt from tax, and high-tax-bracket investors will prefer to hold them rather than short- and long-term taxable bonds. However, the really difficult part of the tax effect to deal with is the fact that capital gains are taxable only if realized through the sale of an asset during the holding period. Investment strategies designed to avoid taxes may conflict with the principles of efficient diversification.

The life cycle approach to the management of an individual's investment portfolio views the individual as passing through a series of stages, becoming more risk averse in later years. The rationale underlying this approach is that as we age, we use up our human capital and have less time remaining to recoup possible portfolio losses through increased labor supply.

People buy life and disability insurance during their prime earning years to hedge against the risk associated with loss of their human capital, that is, their future earning power.

There are three ways to shelter investment income from federal income taxes besides investing in tax-exempt bonds. The first is by investing in assets whose returns take the form of appreciation in value, such as common stocks or real estate. As long as capital gains taxes are not paid until the asset is sold, the tax can be deferred indefinitely.

The second way of tax sheltering is through investing in tax-deferred retirement plans such as IRAs. The general investment rule is to hold the least tax-advantaged assets in the plan and the most tax-advantaged assets outside of it.

Pension plans are either defined contribution plans or defined benefit plans. Defined contribution plans are in effect retirement funds held in trust for the employee by the employer. The employees in such plans bear all the risk of the plan's assets and often have some choice in the allocation of those assets. Defined benefit plans give the employees a claim to a money-fixed annuity at retirement. The annuity level is determined by a formula that takes into account years of service and the employee's wage or salary history.

If the only goal guiding corporate pension policy were shareholder wealth maximization, it would be hard to understand why a financially sound pension sponsor would invest in equities at all. A policy of 100% bond investment would both maximize the tax advantage of funding the pension plan and minimize the costs of guaranteeing the defined benefits.

If sponsors viewed their pension liabilities as indexed for inflation, then the appropriate way for them to minimize the cost of providing benefit guarantees would be to hedge using securities whose returns are highly correlated with inflation. Common stocks would not be an appropriate hedge because they have a low correlation with inflation.