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 Accumulation phase Consolidation phase Spending phase Gifting phase

Individual Investor Life Cycle: Age matters!

Figure 2.1 Accumulation Phase Long-term: Retirement Childrens college Short-term: House Car Consolidation Phase Spending Phase Gifting Phase Long-term: Long-term: Retirement Estate Planning Short-term: Short-term: Vacations Lifestyle Childrens College Needs Gifts

Net Worth

25

35

45

55

65

Age

75

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

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

Constraints:
Liquidity needs Time Horizon Tax Factors Legal/Regulatory Factors Unique needs and preferences

Risk tolerance
Capital preservation Capital appreciation Current income

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

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

Figure 2.5

Investment Value

$10,063 8% Tax Deferred

$5,365 5.76% After Tax Return $1,000

0 10 20 30

Time ears

The Effect of Taxes and Inflation on Investment Returns, 969 - 994

4

Before Taxes

ommon Stocks

After Taxes

8 6 4

After Taxes and Inflation

on -Term overnment Bonds Treasur Bills

unici al Bonds -4

Figure 2.6

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

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 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

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
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
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?