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Investment Objectives. PM must start with a clear objective! Four-step process 1. Devise a policy statement 2. Study current financial/econ. Conditions 3. Construct portfolio 4. Monitor/update investor’s needs and market conditions Applies to individual and institutional investors.

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investment objectives
Investment Objectives
  • PM must start with a clear objective!
  • Four-step process
    • 1. Devise a policy statement
    • 2. Study current financial/econ. Conditions
    • 3. Construct portfolio
    • 4. Monitor/update investor’s needs and market conditions
  • Applies to individual and institutional investors
individual investor life cycle
Individual InvestorLife Cycle
  • Accumulation phase
  • Consolidation phase
  • Spending phase
  • Gifting phase
individual investor life cycle age matters
Individual Investor Life Cycle: Age matters!

Figure 2.1

Accumulation Phase

Long-term: Retirement Children’s college

Short-term: House Car

Consolidation Phase

Long-term: Retirement

Short-term: Vacations Children’s College

Spending Phase Gifting Phase

Long-term: Estate Planning

Short-term: Lifestyle Needs Gifts

Net Worth

Age

life cycle investment goals time horizon and cash needs matter
Life Cycle Investment Goals: Time Horizon and Cash needs Matter
  • Near-term, high-priority goals
  • Long-term, high-priority goals
  • Lower-priority goals
realistic investor goals
Realistic Investor Goals
  • Capital preservation
    • minimize risk of real loss
    • strongly risk-averse or funds needed soon
  • Capital appreciation
    • capital gains to provide real growth over time for future need
    • aggressive strategy with accepted risk
  • Current income
    • generate spendable funds
  • Total return (Maximize total, after-tax return!)
    • capital gains and income reinvestment
    • moderate risk exposure
summary of objectives as input to policy statement
Objectives:

Return

LT vs ST needs

Total Return = Cap Gain + reinvestment income

Risk tolerance

Capital preservation

Capital appreciation

Current income

Constraints:

Liquidity needs

Time Horizon

Tax Factors

Legal/Regulatory Factors

Unique needs and preferences

Summary of Objectives as Input to Policy Statement
investment constraints
Investment Constraints
  • Liquidity needs
    • near-term goals
  • Time horizon
    • longer time horizon favors risk acceptability
    • short time horizon favors less risky investments because losses are harder to overcome in a short time frame
investment constraints taxes matter
Investment Constraints: Taxes Matter
  • Tax concerns
    • interest and dividends taxed at investor’s marginal tax rate
    • capital gains may be unrealized
    • basis and gain or loss realized
    • revisions to capital gains tax rates
    • tradeoff with diversification needs for employer’s stock holdings
    • interest on municipal bonds exempt from federal income tax and from state of issue
    • interest on federal securities exempt from state income tax
    • contributions to an IRA may qualify as deductible from taxable income
    • tax deferral considerations - compounding
effect of tax deferral on investor wealth over time
Effect of Tax Deferral on Investor Wealth over Time

Figure 2.5

Investment Value

$10,063

$5,365

$1,000

Time

the effect of taxes and inflation on investment returns 1969 1994
The Effect of Taxes and Inflation on Investment Returns, 1969 - 1994

Before Taxes

After Taxes

After Taxes and Inflation

Figure 2.6

investment constraints1
Investment Constraints
  • Legal and Regulatory Factors
    • Limitations or penalties on withdrawals
    • Fiduciary responsibilities - “prudent man” rule
    • Investment laws prohibit insider trading
  • Unique Needs and Preferences
    • Personal preferences - socially conscious investments
    • Time constraints or expertise for managing the portfolio may require professional management
    • Large investment in employer may require consideration of diversification needs and realistic liquidity
    • Institutional investors needs
the importance of asset allocation
The Importance of Asset Allocation
  • An investment strategy is based on four decisions
    • What asset classes to consider for investment
    • What normal or policy weights to assign to each eligible class
    • The allowable allocation ranges based on policy weights
    • What specific securities to purchase for the portfolio
  • Most (85% to 95%) of the overall investment return is due to the first two decisions, not the selection of individual investments
the importance of asset allocation suitability and optimality
The Importance of Asset Allocation: Suitability and Optimality
  • Suitability: The appropriateness of particular investments or portfolios of investments for specific investors
  • Optimality: developing a portfolio with the highest expected return for a given level of risk (also called efficiency)
asset allocation and cultural differences
Asset Allocation and Cultural Differences
  • Social, political, and tax environments
  • U.S. institutional investors average 45% allocation in equities
  • In the United Kingdom, equities make up 72% of assets
  • In Germany, equities are 11%
  • In Japan, equities are 24% of assets
scenario 1
Scenario 1
  • 70-year old widow provides her life savings of $300,000 to a financial planner. Portfolio earnings represent nearly all of her income. The planner places 50% of her funds in corporate bonds rated AA or higher and 50% in a variety of vehicles including penny stocks, options, and commodity futures. After two years, interest rates have fallen, but the total value of the portfolio is $240,000 due to losses and trading expenses of managing the speculative portion of the portfolio.
  • Has the planner acted ethically?
  • Is the portfolio suitable?
scenario 2
Scenario 2
  • A 45-year old man with some investment experience opens an account with a discount broker. His wealth is sufficient to allow writing of naked options. He begins trading aggressively, primarily selling puts on stocks and stock indicies. In six months, he has accumulated losses in excess of $100,000.
  • Is the broker acting ethically?
  • Is the portfolio being maintained for him suitable?