How to manage investments in assets (i.e. stocks, bonds etc.) to meet specified investment goals?
How to manage investments in assets (i.e. stocks, bonds etc.) to meet specified investment goals?
Client needs: Investment policy statement
Client needs: Investment policy statement
Focus: Investor’s short-term and long-term needs, expectations
Portfolio manager: Examine current and projected financial, economic, political, and social conditions
Focus: Short-term and intermediate-term expected conditions to use in constructing a specific portfolio
Portfolio manager: Implement the plan by constructing the portfolio
Focus: Meet the investor’s needs at minimum risk levels
Client/Portfolio manager: Feedback loop
Monitor and update investor needs, environmental conditions, evaluate portfolio performance
The preliminaries
The preliminaries
Basic needs
Investment and life cycle net worth
Two important components of the investment policy statement
Investment objectives
Individuals versus institutions
Investment constraints
Individuals versus institutions
Investment Policy Statement: In detail
The preliminaries
The preliminaries
Investment funds after the satisfaction of basic needs (i.e. living cost):
Insurance: Life insurance, Health insurance, Automobile and home insurance.
Cash reserves (i.e. six months’ living expenses): Emergencies, Job layoffs, Investment opportunities.
Investment needs and the life cycle net worth:
Accumulation phase
Consolidation phase Graphically
Spending phase
The preliminaries
The preliminaries
Rise and fall of personal Net worth over the lifetime
The preliminaries
The preliminaries
Benefits from investing early
The preliminaries
The preliminaries
Rise and fall of personal Net worth over the lifetime
Inputs to the investment policy statement
Inputs to the investment policy statement
Investment objectives
Risk return relationship (pyramid game i.e. Ponzi, Afinsa etc.)
What is risk? Risk denotes the probability distribution of possible economic outcomes (danger vs opportunity).
Absolute vs relative risk
Risk tolerance:
Investor’s willingness to accept risk
Investor’s ability to accept risk
Inputs to the investment policy statement
Inputs to the investment policy statement
Investment objectives
Suggested initial asset allocation by investment banks (i.e. TRowePrice.com)
Inputs to the investment policy statement
Inputs to the investment policy statement
Investment objectives
The historical record: Bills, bonds and stocks
Source: BKM Chapter 5 – Sources: Returns on T-bills, large and small stocks – CRSP, T-bonds - RSP for 1926-1995 returns and Lehman Brothers long-term and intermediate indexes for 1996 and later returns.
Inputs to the investment policy statement
Inputs to the investment policy statement
Investment objectives: Question
Based on the historical record over the long-run, stocks outperformed bonds and bills. Why not invest 100% in stocks?
C., Asness, 1996, Why not 100% Equities, The Journal of Portfolio Management.
Inputs to the investment policy statement
Inputs to the investment policy statement
Investment objectives
What is an appropriate investment objective for a 25-year old and a 65-year old investor?
Capital preservation/appreciation: Given the age capital appreciation is more appropriate
Risk tolerance (moderate): Assuming long horizon she must invest in risky assets (i.e. riskier than NYSE index). Equity exposure should range from 70% to 90% and the remaining funds should be invested in bonds or short-term notes.
Capital preservation/appreciation: Given the age capital preservation is more appropriate
Risk tolerance (moderate): Assuming short horizon and capital preservation she must invest around 50% in bonds and 30% in short-term notes. The remaining should be invested in high-quality stocks (i.e. risk similar to S&P 500). This strategy protects from inflation and provides income rather than capital gains.
Inputs to the investment policy statement
Inputs to the investment policy statement
Investment objectives: Individuals versus institutions
Inputs to the investment policy statement
Inputs to the investment policy statement
Investment constraints
Liquidity needs
Liquid assets
Treasury bills vs real estate
Short-term needs
Car, house and college tuition fees
25-year old investor
Little need for liquidity
Possibility for unemployment or honeymoon expense
65-year old investor
Greater need for liquidity
Lifestyle needs for expenses
Inputs to the investment policy statement
Inputs to the investment policy statement
Investment constraints
Time horizon
Long investment horizon generally need less liquidity and can tolerate greater risk
25-year old investor
Due to life expectancies has longer investment time horizon
65-year old investor
Due to life expectancies has shorter investment time horizon
Inputs to the investment policy statement
Inputs to the investment policy statement
Investment constraints
Tax concerns
Taxable income from interest, dividends or rents are taxable at the investor’s marginal rate (i.e. 10%-40%)
Capital gains are taxed differently (i.e. 15%).
Capital gains are taxed when they are realised (i.e. asset is sold) whereas income is taxed when it is received
International investments
25-year old vs 65-year old investor
Depending on their tax bracket may have preferences for different assets i.e. tax-exempt income or tax-deferred plans
Inputs to the investment policy statement
Inputs to the investment policy statement
Investment constraints
Legal and regulatory factors
Fund withdrawal from a 401(k) plan before the age of 59.5 are taxable to an additional 10% penalty
25-year old vs 65-year old investor
Similar concerns for both investors
Inputs to the investment policy statement
Inputs to the investment policy statement
Investment constraints
Unique needs and preferences
Refers to idiosyncratic concerns of each investor
Avoid investments in tobacco companies or environmentally harmful products
Expertise of the portfolio manager
25-year old vs 65-year old investor
Depends on each individual
Inputs to the investment policy statement
Inputs to the investment policy statement
Investment constraints: Individuals versus institutions
c. Investment policy statement: In detail
c. Investment policy statement: In detail
Components of investment policy statement
Brief description of the client
The duties and investment responsibilities of parties involved
The statement of investment objectives/constraints
The schedule for review of both the investment performance and the investment policy statement
Performance measures and benchmarks
Investment strategies/style
Guidelines for rebalancing the portfolio based on feedback
