Topic 9
Individuals & Investment Process
(Chapter 22)
UTS CRICOS 00099F
THE PORTFOLIO MANAGEMENT PROCESS
SETTING A POLICY STATEMENT
 Understand investor’s needs and articulate realistic investment objectives and constraints:
o What are the real risks of an adverse financial outcome, and what emotional reactions will I have?
o How knowledgeable am I about investments and the financial markets?
o What other capital or income sources do I have? How important is this particular portfolio to my overall
financial position?
o How would any unanticipated portfolio value change might affect my investment policy?
Practical Example – Vanguard: https://retirementplans.vanguard.com/VGApp/pe/PubQuizActivity?Step=start
Determination of Portfolio Policies
Constructing the policy statement begins with a profile analysis of the investor’s current and future financial situations
and a discussion of investment objectives and constraints:
RISK OBJECTIVES
 Risk objective should be based on investor’s ability to take risk and willingness to take risk.
 Risk tolerance depends on an investor’s current net worth and income expectations and age.
 More net worth allows more risk taking
 Younger people can take more risk
 A careful analysis of the client’s risk tolerance should precede any discussion of return objectives.
RETURN OBJECTIVES
The return objective may be stated in terms of an absolute or a relative percentage
return. Examples include:
 Capital preservation: Minimize risk of real losses
 Capital appreciation: Growth of the portfolio in real terms to meet future need
 Current income: Focus is in generating income rather than capital gains
 Total return: Increase portfolio value by capital gains and by reinvesting current
income with moderate risk exposure
Example: Identifying return objectives
Assume:
You are a 25-year-old investor…
You are a 60-year-old investor…
Investor
characteristics
…with steady job and adequate insurance
coverage, and enough money in the bank
to provide a cash reserve. Goal: to build a
retirement fund.
…with adequate insurance coverage and a cash
reserve. You are retiring this year and e
expected to live an average of another 20 years
Return
Objective
Given the young age and income growth
potential, a higher-risk strategy such as
total return or capital appreciation objective
would be most appropriate.
A risk-averse investor could choose a mix of
current income and capital preservation; a risktolerant investor will choose a mix of current
income and total return to outpace inflation
Possible
Portfolio
Allocation
Foreign and domestic equity exposure
could range from 80% to 95%. Remaining
funds to be invested in short- and
intermediate-term notes and bonds.
Bonds could comprise 55–65%; of this, 5–15%
to be invested in treasury notes for extra
liquidity and safety. The remaining 35–45% to
be invested in high-quality (e.g., blue-chip)
stocks with risk similar to S&P/ASX200 index
INVESTMENT CONSTRAINTS
Liquidity needs:
o Vary between investors depending upon age, employment, tax status, etc.
o Planned vacation expenses and house down payment are some of the liquidity
needs.
Time horizon:
o Influences liquidity needs and risk tolerance.
o Longer investment horizons generally requires less liquidity and more risk
tolerance.
o Two general time horizons are pre-retirement and post-retirement periods.
INVESTMENT CONSTRAINTS
Tax concerns:
o Capital gains or losses: Taxed differently from
income
o Unrealised capital gains: Reflect price
appreciation of currently held assets not yet
been sold
o Realised capital gains: When the asset has
been sold at a profit
o Trade-off between taxes and diversification:
Tax consequences of selling company shares
for diversification purposes
UNIQUE NEEDS AND PREFERENCES
o Personal preferences such as socially conscious investments could influence
investment choice.
o Time constraints or lack of expertise for managing the portfolio may require
professional management.
o Large investment in employer’s shares may require consideration of diversification
needs.
o Institutional investors needs.
Example: Investment Constraints
Assume:
You are a 25-year-old investor…
You are a 60-year-old investor…
Liquidity Needs
…has little need for liquidity given longterm retirement fund goal. This constraint
may change following some events, e.g.,
unemployment, house down payment, etc.
…has high need for liquidity. Investment
primarily in liquid securities to meet unexpected
expenses or bills.
Time horizon
…long
…very short
Taxes
…is probably in a fairly low tax bracket, so
detailed tax planning will not be a major
concern.
…if in a high tax bracket prior to retiring, tax
situation may change shortly after retirement.
Without large, regular pay checks, the need for
tax-exempt income becomes less.
Regulations
…legal and regulatory matters will be of
little concern, except for insider trading
laws or market manipulation.
…same as 25-year-old plus any estate planning
and set up of trust accounts should follow legal
and tax advice.
Unique needs
…vary with individual circumstances
…vary with individual circumstances
THE IMPORTANCE OF ASSET ALLOCATION
 Policy statement determines types of assets to include in portfolio
1.
2.
3.
4.
What classes should be considered for investment?
What policy weights to assign to each eligible class?
What are the allowable allocation ranges based on policy weights?
What specific securities or funds should be purchased for the portfolio?
 Asset allocation: It is the process of deciding how to distribute an investor’s wealth
among different countries and asset classes for investment purposes.
 According to research studies, most (90%) of the overall investment return is due to
the first two decisions, not the selection of individual investments.
Asset Allocation and Security Selection
RETURNS AND RISKS: DIFFERENT ASSET CLASSES
(from Lecture 1)
 Since higher return comes with higher risk, investor’s ability and/or willingness to
take risk will affect the asset allocation in his or her portfolio
Summary statistics: U.S. sample, December 1925 – December 2019 (annual)
Return
Volatility
Skewness
Min
Max
Inflation
T.Bill (3 mth)
T.Bond (10 yr)
VW stock index#
3.0%
3.4%
5.1%
11.7%
3.8%
3.0%
7.7%
19.9%
0.006
1.017
1.007
-0.439
-10.3%
0.0%
-11.1%
-44.4%
14.4%
14.0%
32.8%
57.4%
VW S&P500 index
7.9%
19.1%
-45.4%
-47.1%
46.6%
IBM
16.8%
29.9%
90.2%
-40.0%
132.0%
# Source:
Internal calculations using data from the Centre for Research in Security Prices, University of Chicago. VW stock index comprises NYSE, Nasdaq, Amex