Introduction

1. Introduction • Setting objectives is important for every person and institution that uses the financial market • Too many investors have a casual attitude • It is easy to be imprecise in communicating with the portfolio manager • Gallup survey finds 39 percent believe stocks will return 15 percent annually for next ten years

2. Introduction (cont’d) • A Pension and Investments article states the importance of setting portfolio objectives: • Two factors contribute to a sponsor’s successful investment program: • Suitable investment objectives and policy • Successful selection of the investment managers to implement policy

3. Semantics • Growth, income, returnoninvestment, and riskmean different things to different people • e.g., a savings account provides income only; it has no growth potential • There must be a clear understanding of the terms when entrusting money to a fund manager

4. Semantics (cont’d) • Interpretation ofprincipalandincome • One interpretation is that principal is the original amount (accumulated interest is not included) • Another interpretation is that accumulated interest is included in principal following the initial year

5. Indecision • The client’s inability to make a decision • e.g., a bank customer wants to have interest compounded but have the interest sent home each month

6. Subjectivity • Investing is both an art and a science • There are inevitably shades of gray that involve subjective judgments • e.g., which stocks are considered “growth” and which are considered “income?”

7. Multiple Beneficiaries • Investment portfolios often have more than one beneficiary • e.g., an endowment fund has a perpetual life • It is possible to increase current income from the portfolio • Benefits today’s beneficiaries • May be at the expense of future beneficiaries • e.g., Social Security and federal unemployment insurance

8. Investment Policy versus Investment Strategy • Investment policy deals with decisions that have been made about long-term investment activities, eligible investment categories, and the allocation of funds among the eligible investment categories • e.g., a pension fund decides never to place more than 30 percent in common stock

9. Investment Policy versus Investment Strategy (cont’d) • Investment strategy deals with short-term activities that are consistent with established policy and that will contribute positively toward obtaining the objective of the portfolio • e.g., a manager may be required to maintain at least 30 percent equity by policy but decides to put 50 percent in the stock market because of a belief that the market will advance in the near future

10. Portfolio Objectives • Preconditions • Traditional Portfolio Objectives • Special Situation of Tax-Free income • Portfolio Objectives and Expected Utility

11. Preconditions • Questions to be answered before setting objectives and formulating strategy: • Assess the existing situation • What are the current needs of the beneficiary? • What is the investment horizon? • Are there special liquidity needs? • Are there ethical investing concerns established by the fund’s owner or overseer?

12. Traditional Portfolio Objectives • Stability of Principal • Income • Growth of Income • Capital Appreciation

13. Stability of Principal • Emphasis is on preserving the “original” value of the fund • The most conservative portfolio objective • Will generate the most modest return over the long run

14. Stability of Principal (cont’d) • Appropriate investment vehicles: • Bank certificates of deposit • Other money market instruments

15. Income • No specific proscription against periodic declines in principal value • e.g., a Treasury note may experience a decline in value if interest rates rise, but the investor will not experience a loss if he holds the note to maturity

16. Income (cont’d) • Appropriate investment vehicles: • Corporate bonds • Government bonds • Government agency securities • Preferred stock • Common stock

17. Growth of Income • Benefits from time value of money • Sacrifices some current return for some purchasing power protection • Differs from income objective • Income lower in earlier years • Income higher in later years

18. Growth of Income (cont’d) • This objective often seeks to have the annual income increase by at least the rate of inflation • Requires some investment in equity securities

19. Growth of Income (cont’d) Example Two portfolios have an initial value of $50,000. Interest rates are expected to remain at a constant 10 percent per year for the next ten years. Portfolio A has an income objective and seeks to provide maximum income each year. The portfolio is invested 100 percent in debt securities. Thus, Portfolio A generates $5,000 in income each year.

20. Growth of Income (cont’d) Example (cont’d) Portfolio B seeks growth of income and contains both debt and equity securities. Portfolio B has an annual total return of 12 percent. In the first year, Portfolio B provides $3,500 in income (a 7 percent income yield) and experiences capital appreciation of 5 percent. The income generated by both portfolios over the next ten years is shown graphically on the following slide.

21. Growth of Income (cont’d) Example (cont’d)

22. Capital Appreciation • The goal is for the portfolio to grow in value rather than generate income • Appropriate for investors who have no income needs

23. Capital Appreciation (cont’d) • A major benefit is tax savings • Unrealized capital gains are not taxed • Dividend and interest income is taxed • The investor can defer taxes for many years by successful long-term growth stock investing

24. Capital Appreciation (cont’d) Example Consider two $10,000 investments. Both investments have a 10 percent expected rate of return annually on a pretax basis. Investment A involves the purchase of 500 shares of a $20 common stock that does not pay dividends. Investment B involves the purchase of 500 shares of a $20 common stock that has a constant dividend yield of 7 percent.

25. Capital Appreciation (cont’d) Example (cont’d) Consider an investor in the 28 percent tax bracket. The investor will hold both investments for four years. The projected cash flows over the next four years for both investments and the corresponding IRR calculations are shown on the next slides.

26. Capital Appreciation (cont’d)

27. Capital Appreciation (cont’d) Example (cont’d) If the investor does not sell Investment A after four years, his after-tax internal rate of return is:

28. Capital Appreciation (cont’d) Example (cont’d) If the investor sells Investment A after four years, his year 4 cash flow is reduced by capital gains taxes of $2.60 and his after-tax internal rate of return is:

29. Capital Appreciation (cont’d)

30. Capital Appreciation (cont’d) Example (cont’d) If the investor does not sell Investment B after four years, his after-tax internal rate of return is:

31. Capital Appreciation (cont’d) Example (cont’d) If the investor sells Investment B after four years, his year 4 cash flows is reduced by capital gains taxes of $0.70, and his after-tax internal rate of return is:

32. Special Situation of Tax-Free Income • Accomplished by investing in municipal securities • Free from federal tax and may be free from state and local taxes • Invest directly in municipal bonds for an income strategy • Invest in a mix of municipal bonds and common stock for a growth-of-income strategy

33. Special Situation of Tax-Free Income (cont’d) • Invest in a municipal bond mutual fund for a stability of principal strategy • Tax-free income generation is unrealistic for a capital appreciation strategy

34. Portfolio Objectives and Expected Utility • Utility is one of the most useful of all economic concepts • We seek out satisfying things and avoid things that cause discomfort • Utility comes from quantifiable and nonquantifiable sources • e.g., an investor may choose his own stocks rather than investing in mutual funds for the “thrill of the hunt”

35. The Importance of Primary and Secondary Objectives • Introduction • Possible Combinations of Objectives

36. Introduction • The secondary objective indicates what is next in importance after specification of the primary objective • e.g., an investor chose income as the primary objective, but: • Does not want to take a lot of risk with the invested money (stability of principal) • Wants to keep up with inflation (growth of income)

37. Primary Objective Secondary Objective Stability of Principal Income Growth of Income Capital Appreciation Stability of Principal X Debt and Preferred Stock Unacceptable Goals ? Income Short-term debt X At least 40% equity ? Growth of Income Unacceptable goals Varies: often > 40% equity X At least 75% equity Capital Appreciation Unacceptable goals ? At least 75% equity X ? = unusual combinations involving a need to tailor a portfolio to a very specific need. X = not applicable. Possible Combinations of Objectives

38. Other Factors to Consider in Establishing Objectives • Inconsistent Objectives • Infrequent Objectives • Portfolio Splitting • Liquidity • The Role of Cash

39. Inconsistent Objectives • Certain primary/secondary combinations are incompatible • Primary: stability of principal • Secondary: capital appreciation • “I want no chance of a loss, but I do want capital gains”

40. Infrequent Objectives • Certain primary/secondary combinations are infrequent • Primary: capital appreciation • Secondary: stability of principal • Could invest in low coupon bonds selling at a substantial discount from par and hold the bond to maturity

41. Portfolio Splitting • A fund manager receives instructions that require that the portfolio be managed in more than one part • e.g., endowment funds • Components will have different objectives • A more convenient way of administering the fund than trying to establish a single, overall objective

42. Liquidity • Liquidity is a measure of the ease with which something can be converted to cash • Clients may desire some liquidity • Options: invest a portion of the portfolio in money market mutual funds or cash management accounts at brokerage firms with check-writing privileges

43. The Role of Cash • Investment management firms routinely prescribe portfolio proportions for: • Equity securities • Fixed-income securities • Cash • Arrives in portfolios naturally though the receipt of dividends and interest

44. The Role of Cash (cont’d) • Cash contributes to portfolio stability, especially during periods of rising interest rates • Cash includes: • Currency • Money market instruments • e.g., Treasury bills • Short-term interest-bearing deposit accounts