essay
Chapter
22
Investors and the Investment Process
Bodie, Kane, and Marcus
Essentials of Investments
Tenth Edition
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Table 22.1 Components of Investment Management Process (1 of 2)
Planning
Identifying and specifying the investor's objectives and constraints
Creating the investment policy statement [See Table 22.2]
Forming capital market expectations
Creating the strategic asset allocation (Target minimum and maximum class weights)
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Table 22.1 Components of Investment Management Process (2 of 2)
Execution: Portfolio construction and revision
Asset allocation (including tactical) and portfolio optimization (Combine assets to meet risk and return objectives)
Security selection
Implementation and execution
Feedback
Monitoring (investor, economic, and market input factors)
Rebalancing
Performance evaluation
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Figure 22.1 Investment Management Process
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Table 22.2 Components of Investment Policy Statement
Brief client description
Purpose of establishing policies and guidelines
Duties and investment responsibilities of parties involved
Statement of investment goals, objectives, and constraints
Schedule for review of investment performance and the IPS
Performance measures and benchmarks
Any considerations in developing strategic asset allocation
Investment strategies and investment styles
Guidelines for rebalancing
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Table 22.3 Determination of Portfolio Policies
| Objectives | Constraints |
| Return requirements | Liquidity |
| Risk tolerance | Horizon |
| Regulations | |
| Taxes | |
| Unique needs, such as: | |
| Ethical concerns | |
| Specific hedging needs | |
| Age | |
| Wealth |
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22.2 Investor Objectives (1 of 5)
Individual Investors
Balance risk/return throughout life
Wealth shifts from human capital to financial capital with age, increasing portfolio choice importance
Life cycle critical in determining risk-return trade-off
Younger investors
Willing to bear more risk for higher returns
Older investors
Willing to accept lower returns for lower risk
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22.2 Investor Objectives (2 of 5)
Professional Investors
Personal trusts
Trustee holds interest in asset for benefit of another person
Management subject to prudent investor rules
Mutual funds
Objectives vary with type of fund
Detailed in prospectus
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22.2 Investor Objectives (3 of 5)
Pension funds
Defined benefit: Depends on tenure, salary; investment risk borne by company
Defined contribution: Employee and employer contribute set amount to individual’s retirement fund; benefit depends on investment performance; investment risk borne by individual
Endowment funds
Gifts to nonprofits that are invested
Funds from endowment used by the nonprofit
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22.2 Investor Objectives (4 of 5)
Insurance Companies
Life insurance companies
Term insurance
Whole-life policies (insurance + savings at fixed rate)
Variations of the two with variable-rate savings
Investments set up as hedges against potential claims of policyholders
Non-life-insurance companies
Premiums not paid back to policyholders for losses, are invested
Hedge against potential claims
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22.2 Investor Objectives (5 of 5)
Banks
Sources of funds: predominantly deposits, some borrowed funds
Investment of funds: predominantly loans and fixed-income securities
Active in securitized loan and asset markets
Not active in equity except in trust function
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Table 22.4 Matrix of Objectives
| Type of Investor | Return Requirement | Risk Tolerance |
| Individual and personal trusts | Life cycle (education, children, retirement) | Life cycle (younger are more risk tolerant) |
| Mutual funds | Variable | Variable |
| Pension funds | Assumed actuarial rate | Depends on proximity of payouts |
| Endowment funds | Determined by current income needs and need tor asset growth to maintain real value | Generally conservative |
| Life insurance companies | Should exceed new money rate by sufficient margin to meet expenses and profit objectives; also actuarial rates important | Conservative |
| Non-life-insurance companies | No minimum | Conservative |
| Banks | Interest spread | Variable |
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22.3 Investor Constraints (1 of 3)
Liquidity
Speed and ease with which asset can be converted into cash
Need for cash on short notice increases liquidity requirement, decreases return
Investment Horizon
Planned liquidation date
Affects portfolio risk and security maturity dates
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22.3 Investor Constraints (2 of 3)
Regulations
Institutional investors
Example: Mutual funds may not hold more than 5% of the stock of any publicly traded corporation
Prudent investor rule
The fiduciary responsibility of a professional investor
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22.3 Investor Constraints (3 of 3)
Tax Considerations
Special considerations related to tax position of investor
Unique Needs
Special considerations related to underlying investors
Diversify away from industry in which they work
Financial needs may determine riskiness of portfolio
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Table 22.5 Matrix of Constraints
| Type of Investor | Liquidity | Horizon | Regulatory | Taxed |
| Individuals and personal trusts | Variable | Life cycle | Prudent investor laws (for trusts) | Variable |
| Mutual funds | Low | Short | Little | None |
| Pension funds | Young, low; mature, high | Long | ERISA | None |
| Endowment funds | Little | Long | Little | None |
| Life insurance companies | Low | Long | Complex | Yes |
| Non-life-insurance companies | High | Short | Little | Yes |
| Banks | Low | Short | Changing | Yes |
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22.4 Investment Policies (1 of 3)
Asset Allocation Decision
Money market assets
Based on liquidity needs; used to gain more diversification
Fixed-income securities
Primarily bonds; gain diversification and safety with higher real return than money market
Stocks
Value versus growth
Large versus small
Sector weights
Dividend versus capital gains
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22.4 Investment Policies (2 of 3)
Non-U.S. stocks and bonds
Real estate
REITs
Direct holdings
Precious metals and other commodities
Difficult to predict value; no cash flow
Choices determined by:
Capital market expectations
Risk tolerance
Financial needs
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22.4 Investment Policies (3 of 3)
Top-Down Policy for Institutional Investors
Investment Committee
Comprised of senior management; formulates investment policies and verifies implementation
Establishes asset universe (approved list of assets in which company’s portfolios may invest)
Formulates broad asset allocation decisions
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Figure 22.2 Asset Allocation and Security Selection, Partial Investments
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22.4 Investment Policies: Active vs. Passive
| Active | Passive |
| Aims for Better than Average Returns | Aims for Average Returns |
| Active Asset Allocation | Does not Attempt to Time the Market |
| Active Security Selection | Indexing |
| Balance Likelihood of Better Returns with Costs | Seeks Low Cost Financial Products |
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22.5 Monitoring and Revising Investment Portfolios
By time of completion of investment steps, inputs may be out of date, necessitating strategy revisions
Client circumstances can change over time
Portfolio weights will change over time as prices change
Asset allocation will change over time
Investing is a dynamic process that must be updated and reevaluated
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