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Investment Analysis and Portfolio Management

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Investment Analysis & Portfolio Management (FIN630)
Lesson # 38
Formulate an Appropriate Investment Policy:
The determination of portfolio policies--referred to as the investment policy statements is
the first step in the investment process. It summarizes the objectives, constraints, and
preferences for the investor. A recommended approach in formulating ah investment policy
statement is simply to provide information, in the following order, for any investor
individual or institutional:
Return requirements
Risk tolerance
Followed by:
Constraints and Preferences:
o Liquidity
o Time horizon
o Laws and regulations
o Taxes
o Unique preferences and circumstances
Portfolio objectives are always going to center on return and risk, because these are the two
aspects of most interest to investors. Indeed, return and risk are the basis of all financial
decisions in general and investing decisions in particular. Investors seek returns, but must
assume risk in order to have an opportunity to earn the returns.
Furthermore, an individual can be a composite of these stages at the same time. The four
stages are:
1. Accumulation Phase: In the early stage of the life cycle, net worth is typically small,
but the time horizon is long. Investors can afford to assume large risks.
2. Consolidation Phase: In this phase, involving the mid-to-late career stage of the life
cycle when income exceeds expenses, an investment portfolio can be .accumulated.
A portfolio balance is sought to provide a moderate trade-off between risk and
3. Spending Phase: In this phase, living expenses are covered from accumulated assets
rather than earned income. Although some risk taking is still preferable, the
emphasis is on safety, resulting in a relatively low position on the risk-return trade-
4. Gifting Phase: In this phase, the attitudes about the purpose of investments changes.
The basic position on the trade-off remains about the same as in phase 3.
Establishing a Portfolio Risk Level:
Investors should establish a portfolio risk level that is suitable for them, and then seek the
Investment Analysis & Portfolio Management (FIN630)
highest returns consistent with that level of risk. We will assume here that investors have a
long-run horizon. If not, they probably should avoid stocks, or at least minimize any equity
Assuming you are a long-term investor, and that you own an S&P 500-type portfolio, ask
yourself what is the worst that is likely to happen to you as an investor in stocks. Ignoring
the Great Depression, which hopefully will not occur again, consider the worst events that
have, occurred. During the bear market of 1973 to 1974, investors could have lost about 37
percent of their investment in S&P 500 stocks. During the bear market of 2000 to 2002,
investors could have lost over 40 percent. Therefore, it is reasonable to assume that with a
long-time horizon, investors will face one or more bear markets with approximately 40
percent declines. This is in line with the long-term standard deviation of S&P 500 returns of
about 20 percent with two standard deviations on either side of the mean return
encompassing 95 percent of all returns.
If an investor can accept a loss (at least on paper) of approximately 40 percent once or twice
in an investing life time, and in otherwise optimistic about the economy and about stocks,
the investor can assume the risk of U.S. stocks. On the other hand, if such a potential
decline is unacceptable, an investor will have to construct a portfolio with a lower risk
profile. For example, a portfolio of 30 percent stocks and 50 percent Treasury bills would
cut the risk in half. Other alternatives consisting of stocks and bonds would also decrease
the risk.
Inflation Considerations:
An investment policy statement often will contain some statement about inflation-adjusted
returns because of the impact of inflation on investor results over long periods of time. For
example, a wealthy individual's policy statement may be stated in terms of maximum. After
tax, inflation-adjusted total return consistent with the investor's rise profile, whereas another
investor's primary return objective may be stated as inflation-adjusted capital preservation,
perhaps with a growth-oriented mix to reflect the need for capital growth over time.
Inflation is clearly a problem for investors. The inflation rate of 13 percent in 1979 to-1980
speaks for itself in terms of the awful impact it had on investors' real wealth. But even with
a much lower inflation--say, 3 percent--the damage is substantial. It can persist steadily,
eroding values. At a 3 percent inflation rate, for example, the purchasing power of a dollar
is cut in half in 10s than 25 years. Therefore, someone retiring at age 60 who lives to
approximately age 85 and does not protect him or herself from inflation will suffer a drastic
decline in purchasing power over the years.
The very low inflation rates of the late 1990s and early 2000s probably lulled many
investors into thinking that inflation is no longer a serious problem, and that they did not
need to consider this issue as being very important. However, for the last 80 or so years, the
compound annual rate of inflation has been approximately 3 percent. It is reasonable to
assume that in the future inflation will| be higher than it has been recently, and therefore this
is an issue that investors need to consider.
Constraints and Preferences:
To complete the investment policy statement, these items are described for a particular
investor as the circumstances warrant. Since investors vary widely in their constraints and
preferences, these details may also vary widely. Time Horizon Investors need to think about
the time period involved in their investment plans. The objectives being pursued may
Investment Analysis & Portfolio Management (FIN630)
require a policy statement that speaks to specific planning horizons. In the case of an
individual investor, for example; this could well be the investor's expected lifetime. In the
case of an institutional investor, the time horizon can be quite long. For example, for a
company with a defined benefit retirement plans whose employees are young; and which
has no short-term liquidity needs, the time horizon can be quite long.
Liquidity Needs:
Liquidity is the ease with, which an asset can be sold without a sharp change in price as the
result of selling. Obviously, cash equivalents (money market securities) have high liquidity,
and are easily sold at close to face value. Many stocks also have great liquidity, but the price
at which they are sold will reflect their current market valuations.
Investors' must decide how likely they are to sell some part of their portfolio in the
short run. As part of the asset allocation decision, they must decide how much of their
funds to keep in cash equivalents.
Tax Considerations:
Individual investors, unlike some institutional investors, must consider the impact of taxes
on their investment programs. The treatment of ordinary income as opposed to capital gains
is an important issue, because typically there is a differential tax rate. Furthermore, the tax
laws in United States have been changed several times, making it difficult for investors to
forecast the tax rate that will apply in the future.
In addition to the differential tax rates and their changes over time, the capital gains
component of security returns benefits from the fact that the tax is not payable until the gain
is realized. This tax deferral is, in effect a tax-free loan that remains invested for the benefit
of the taxpayer. As -explained below, some securities become "locked up" by the reluctance
of investors to pay the capital gains that will result from selling the securities.
Retirement programs offer tax sheltering whereby any income and/or capital gains taxes are
avoided until such time as the funds are withdrawn. Investors with various retirement and
taxable accounts must grapple with the issue of which type of account should hold stocks as
opposed to bonds (given that bonds generate higher current Income).
Legal and Regulatory Requirements:
Investors must obviously deal with regulatory requirements growing out of both common
law and the rulings and regulations of state and federal agencies. Individuals are subject to
relatively few such requirements, whereas a particular institutional portfolio, such as an
endowment fund of a pension fund, is subject to several legal and regulatory requirements.
With regard to fiduciary responsibilities, one of the most famous concepts is the Prudent
Man Rule. This rule, which concerns fiduciaries, goes back to 1830, although it was not
formally stated until more than 100 years later. Basically, the rule states that a fiduciary, in
managing assets for another party shall act like people of prudence, discretion and
intelligence act in governing their own affairs.
The important aspect of the Prudent Man Rule is its flexibility; because interpretations of
the rule can change with time and circumstances. Unfortunately, some judicial rulings have
specified a very strict interpretation, negating the, value of flexibility for the time period and
circumstances involved. Also unfortunately, in the case of state laws governing private
Investment Analysis & Portfolio Management (FIN630)
trusts the standard continues to be applied to individual investments rather than the portfolio
as a whole which violates all of the portfolio-building principles.
One of the important pieces of federal legislation governing institutional investors is the
Employment Retirement Income Security Act, referred to as ERISA. This act, administered
by the Department of Labor, regulates employer-sponsored retirement plans. It requires that
plan assets be diversified and that the standards being applied under the act be applied to
management of the port/olio as a whole.
The investment policy thus formulate is an operational statement. It clearly specifies the
actions to be taken to try to achieve the investor's goals, or objectives, given the preferences
of the investor and any constraints imposed. Although portfolio investments consider aliens
are often of a qualitative nature, they help to determine a quantitative statement of return
and risk requirements that are specific to the needs of any particular investor.
Unique Needs and Circumstances:
Investors often face a variety of unique circumstances. For example, a trust established on
their behalf may specify that investment activities be limited to particular asset classes, or
even specified assets. Or in individual may feel that their life span is threatened by illness
and wish to benefit within a certain period of time.
Determine and Quantify Capital Market Expectations:
Having considered their objective's and constraints, the next step is to determine a set, of
investment strategies based on the policy statement. Included here ape such issues as asset
allocation portfolio diversification and the impact of taxes. Once the portfolio strategies are
developed, they are used along with the investment manager's expectations' fit the capital
market and' for individual assets to choose a portfolio of assets. Most importantly, the asset
allocation decision must be made.
Forming Expectations:
The forming of expectations involves two steps:
1. Macroexpectational factors: These factors influence the market for bonds, stocks
and other assets on both a domestic and international basis. These are expectations
about the capital markets.
2. Microexpectational influences: These factors invoke the cause agents that underlie
the desired return and risk estimates and influence the selection of a particular asset
for a particular portfolio.
Rate of Return Assumptions:
Most investors base their actions on some 'assumptions about the rate of return expected
from various assets, obviously it is important to investors to plan their investing activities
on realistic rate of return assumptions.
Investors should study carefully the historical rates of return available in such sources as the
data provided by Ibbotson Associates or the comparable data. We know the historical mean
returns, both arithmetic and geometric, and the standard deviation of the returns for major
asset classes such as stocks, bonds and bills.
Investment Analysis & Portfolio Management (FIN630)
Asset Allocation:
The asset allocation decision involves .deciding the percentage of investable funds to be
placed in stocks, bonds, and cash equivalents. It is the most important investment decision
made by investors, because it is the basic determinant of the return and risk taken.
The returns of a well-diversified portfolio within a given asset class are highly correlated
with the returns of the asset class itself. Within an asset class, diversified portfolios will tend
to produce similar returns over time. However, different asset classes are likely to produce
results that ire quite dissimilar. Therefore, differences in asset allocation will be the key
factor over time causing differences in portfolio performance.
The Asset Allocation Decision:
Factors to consider in making the asset allocation decision include the investor's return
requirements (current income versus future income), the investor's risk tolerance, and the
time horizon. This is done in conjunction with the investment manager's expectations about
the Capital markets and about individual assets.
How asset allocation decisions are made by investors remains a subject that is not fully
understood. It is known that actual allocation decisions often differ widely from how
investors say they will allocate assets.
Types of Asset Allocation:
William Sharpe has outlined several types of asset allocation. If all major aspects of the
process have been considered, the process is referred to as integrated asset' allocation. These
include issues specific to an investor, particularly the investor's risk tolerance, and issues
pertaining to the capital markets, such as predictions concerning expected returns, risks, and
correlations. If some of these steps are omitted, the asset allocation approaches are more
specialized. Such approaches include:
1. Strategic asset allocation: This type of .allocation is usually done once every few
years; using simulation procedures to determine the likely range of outcomes
associated with each mix. The investor considers the range of outcomes for each
mix; and chooses the preferred one, thereby establishing a long-run or strategic asset
2. Tactical asset allocation: This type of allocation is performed routinely, as part of
the ongoing process of asset management. Changes in asset mixes are driven by
changes in predictions concerning asset returns. As predictions of the expected
returns on stocks, bonds, and other assets change, the percentages of these assets
held in the portfolio changes. In effect, tactical asset allocation is a market timing
approach to portfolio management intended to increase exposure to a particular
market when its performance is expected to be good and decrease exposure when
performance is expected to be poor.
Changes in Investor's Circumstances:
An investor's circumstances can change for several reasons. These can be easily organized
on the basis of the framework for determining portfolio policies outlined above.
Investment Analysis & Portfolio Management (FIN630)
1. Change in Wealth: A change in wealth may cause an investor to behave differently,
possibly accepting more risk in the case of an increase in wealth, or becoming more
risk averse In the case of, a decline in wealth.
2. Change in Time Horizon: Traditionally, we think of investors aging and becoming
more conservative in their investment approach.
3. Change in Liquidity Requirements: A need for more current income could increase
the emphasis on dividend-paying stocks, whereas a decrease in current income
requirements could lead to greater investment in small stocks whose potential payoff
may be, years in the future.
4. Change in Tax Circumstances: An investor who moves to a higher tax bracket may
find municipal bonds more attractive. Also, the timing of the realization of capital
gains can become more important.
5. Change in Legal / Regulatory Considerations: Laws affecting investors change
regularly, whether tax laws or laws governing retirement accounts, annuities, and so
6. Change in Unique Needs and Circumstances: Investors face a number of possible
changes during their life depending on many economic, social, political, health; and
work-related factors.
Rebalancing the Portfolio:
Even the most carefully constructed portfolio is not intended to remain intact without
change. Portfolio managers spend much of their time monitoring their portfolios and doing
portfolio rebalancing. The key is to know when arid how to do such rebalancing because a
trade-off is involved the cost of trading versus the cost of not trading.
The cost of trading involves commissions, possible impact on market price, and. the time
involved in deciding to trade. The cost of not trading involves holding positions that are not
best suited for the portfolio's owner, holding positions that violate the asset allocation plan,
hording a portfolio that is no longer adequately diversified and so forth.
One of the problems involved in rebalancing is the "lock-up" problem. This situation arises
in taxable accounts subject to capital gains taxes. Even at low level of turnover the tax
liabilities generated can be larger than the gains achieved by the active management driving
the turnover. In the absence of taxes, such, as with tax deferred IRA and 401(k) plans,
investors would simply seek to hold those securities with the highest risk adjusted expected,
rates of return.
Performance Measurement:
The portfolio management process is designed to facilitate making investment decisions in
an organized, systematic manner. Clearly, it is important to evaluate the effectiveness, of the
overall decision-making process. The measurement of portfolio performance allows
investors to determine the success of the portfolio management process and of the portfolio
manager. It is a key part of monitoring the investment strategy that was based on investor
objectives, constraints and preferences.
Performance measurement is important to both those who employ a professional portfolio
manager, on their behalf as, well as to those who invest personal funds. It allows investors
to evaluate the risks that are being taken, the reasons for the success or failure of the
investing program; and the costs of any restrictions that may have been placed on the
investment manager.
Investment Analysis & Portfolio Management (FIN630)
Unresolved issues remain in performance measurement despite the development of an entire
industry to provide data and analyses of expost performance. Nevertheless, it is a critical
part of the investment management process, and the logical capstone in its, own right of the
entire study of investments.