Essentials of Investments: Chapter 21 - Investors and the Investment Process

Essentials of Investments: Chapter 21 - Investors and the Investment Process The Four Stages of the Investment Proce (Specifying objectives, Specifying constraints, Formulating policy, Monitoring and updating portfolio).

CHAPTER 21

Investors and the Investment

Process

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The Four Stages of the Investment Process

1 Specifying objectives

2 Specifying constraints

3 Formulating policy

4 Monitoring and updating portfolio

Specifying Objectives

• Investment managers

must assess the level

of risk investors can

tolerate in pursuit of

higher returns.

• Objectives and risk tolerance differ by type of investor.

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Figure 28.1 CFA Institute Investment

Management Process

Table 28.1 Components of the Investment

Management Process

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Table 28.2 Components of the Investment

Policy Statement

Table 28.3 Determination of Portfolio

Policies

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Table 28.4 Matrix of Objectives

• Liquidity

– Ease (speed) with which an asset can

be sold and created into cash

• Investment horizon - planned liquidation

date of the investment

• Regulations

– Prudent investor rule

• Tax considerations

• Unique needs

Specifying Constraints on

Investment Policies

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Table 28.5 Matrix of Constraints

Policy Statements

• The Policy Statement (IPS) provides for:

– Governance of the investment program,

– The appropriate asset allocation,

– Roles of internal and/or external managers,

– Monitoring the results,

– Risk management,

– Appropriate reporting,

– Accountability

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Asset Allocation

• By far the most

important part of

policy determination

is asset allocation,

that is, deciding how

much of the portfolio

to invest in each

major asset category.

1 Specify asset

classes

2 Specify capital

market expectation

3 Derive the efficient

portfolio frontier.

4 Find the optimal

asset mix.

5 Manage taxes.

Managing Portfolios of Individual Investors

• Human capital and insurance

• Investment in residence

• Saving for retirement and the

assumption of risk

• Retirement planning models

• Manage your own portfolio or rely on

others?

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Tax Sheltering for Individual Investors

• Tax-deferral option - controlling the

timing of gains on investments

• Tax-deferred retirement plans

– IRAs

– Keogh plans

• Deferred annuities

– Fixed

– Variable

• Variable and universal life insurance

Pension Funds

• Defined contribution plans

– Investment policy is essentially the

same as for a tax-qualified individual

retirement account

• Defined benefit plans

– Contractual arrangement setting out the rights and obligations of all parties

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Pension Funds

• The tax status of pension funds

makes them favor assets with the

largest spread between pretax and

after-tax rates of return.

• Pension funds make use of

immunization.

• Investing in equities occurs for both

correct and wrong reasons.

Investments for the Long Run

• Advice from the mutual fund industry:

• Don’t try to outguess the market by moving

your money in and out Buy and hold instead

• Diversify to reduce risk

• Put money in stocks, bonds, and money

market mutual funds

• Avoid keeping 401(k) money in a company’s

low-risk default investment scheme.

• Be wary of investing a large percentage of your

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Investments for the Long Run

• Investment horizon determines which

risk-free rate to choose

• Make simple investment choices such as

TDRFs (target date retirement funds)

• Inflation risk and long-term investors:

– TIPS are helpful but not really risk-free.

– Market value can fluctuate.

– Reinvestment rate risk