Chapter 21


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Chapter 21

  2. 2. The Investment Management Process Evaluate Investor Market, Investor & Portfolio Monitored Investment Strategy & Asset Allocation Portfolio Changed to reflect changes
  3. 3. <ul><li>Must evaluate objectives and constraints of an investor to be able to provide suitable investment advice </li></ul><ul><li>“ know your client” legislation </li></ul><ul><li>Objectives are in terms of risk and return </li></ul><ul><li>Constraints are things that limit ability to take on risk, or limit types of investment that can be made </li></ul><ul><li>Note that markets and investor are monitored continuously - Portfolio management process is a continuum, it never stops . </li></ul>Evaluate Investor
  4. 4. <ul><li>Objectives of Investor - Risk : </li></ul><ul><ul><ul><li>Ability to accept risk affected by: </li></ul></ul></ul><ul><ul><ul><ul><ul><li>spending needs </li></ul></ul></ul></ul></ul><ul><ul><ul><ul><ul><li>long term targets & obligations </li></ul></ul></ul></ul></ul><ul><ul><ul><ul><ul><li>financial strength </li></ul></ul></ul></ul></ul><ul><ul><ul><ul><ul><li>individual characteristics (willingness to take on risk) </li></ul></ul></ul></ul></ul>Evaluate Investor
  5. 5. <ul><li>Objectives of Investor - Return : </li></ul><ul><ul><ul><ul><li>Return objectives must be consistent with risk objectives! </li></ul></ul></ul></ul><ul><ul><ul><ul><li>May be specific (i.e. an actual %) </li></ul></ul></ul></ul><ul><ul><ul><ul><li>May be more general (e.g. capital preservation, income, or growth of capital) </li></ul></ul></ul></ul><ul><ul><ul><ul><li>Should account for effect of inflation </li></ul></ul></ul></ul>Evaluate Investor
  6. 6. <ul><li>Investment Constraints </li></ul><ul><ul><li>limit investment choices </li></ul></ul><ul><ul><ul><li>Liquidity </li></ul></ul></ul><ul><ul><ul><ul><li>expected/unexpected cashflows </li></ul></ul></ul></ul><ul><ul><ul><li>Time Horizon </li></ul></ul></ul>Evaluate Investor Will affect ability to accept risk
  7. 7. <ul><ul><ul><li>(c) Tax </li></ul></ul></ul><ul><ul><ul><ul><li>capital gains versus income </li></ul></ul></ul></ul><ul><ul><ul><li>(d) Legal and Regulatory Factors </li></ul></ul></ul><ul><ul><ul><ul><li>mostly institutional investors </li></ul></ul></ul></ul><ul><ul><ul><ul><li>“ Prudent Man Rule” </li></ul></ul></ul></ul><ul><ul><ul><li>(e) Unique Circumstances </li></ul></ul></ul>Evaluate Investor
  8. 8. <ul><li>To evaluate an investor and their investment needs, sometimes useful to look at what point in the life cycle they are in </li></ul><ul><li>Life Cycle: investment needs (objectives, constraints) change as people go through different stages of life </li></ul>Evaluate Investor
  9. 9. <ul><li>General Stages of Life Cycle: </li></ul><ul><li>1. Accumulation Phase: </li></ul><ul><ul><ul><li>Early to middle working years, starting to accumulate wealth </li></ul></ul></ul><ul><ul><ul><li>Net worth usually small (often have debt) </li></ul></ul></ul><ul><ul><ul><li>Typically long investment horizon, therefore able to take on more risk </li></ul></ul></ul><ul><ul><ul><li>Emphasis on capital appreciation </li></ul></ul></ul><ul><ul><ul><li>May have some shorter term goals (buy house, buy car etc.) </li></ul></ul></ul>Evaluate Investor
  10. 10. <ul><li>2. Consolidation phase: </li></ul><ul><ul><ul><li>20 or 30 years to retirement </li></ul></ul></ul><ul><ul><ul><li>Salary has increased so earnings exceed expenses, therefore do not need much liquidity from investments </li></ul></ul></ul><ul><ul><ul><li>Time horizon still long so able to take moderate amounts of risk, but less risk tolerance than in accumulation phase </li></ul></ul></ul><ul><ul><ul><li>Emphasis on capital appreciation, do not need income </li></ul></ul></ul>Evaluate Investor
  11. 11. <ul><li>3. Spending Phase </li></ul><ul><ul><ul><li>Retirement </li></ul></ul></ul><ul><ul><ul><li>Since do not earn money now, protection of capital is important. Take less risk. </li></ul></ul></ul><ul><ul><ul><li>Emphasis on current income provided by investments (rather than appreciation) </li></ul></ul></ul><ul><ul><ul><li>many years of life left, so some growth still needed (to protect against inflation) </li></ul></ul></ul><ul><ul><ul><li>May be need for liquidity in investments to meet unexpected expenses </li></ul></ul></ul>Evaluate Investor
  12. 12. <ul><li>4. Gifting Phase: </li></ul><ul><ul><ul><ul><li>Basic risk/return trade off is same as in spending phase, but the purpose of investing has changed </li></ul></ul></ul></ul><ul><ul><ul><ul><li>general goal now is to maximize amount that can be given to relatives or charity. </li></ul></ul></ul></ul>Evaluate Investor and Market
  13. 13. <ul><li>After evaluating investor, evaluate markets </li></ul><ul><ul><ul><li>Form expectations about returns </li></ul></ul></ul><ul><ul><ul><li>May be based, in part, on historical averages </li></ul></ul></ul><ul><ul><ul><li>E.g. average return on TSX is 10.32% per year, from 1938-2003 </li></ul></ul></ul><ul><ul><ul><li>BUT…past performance is no guarantee of future performance </li></ul></ul></ul>Investment Strategy & Asset Allocation
  14. 14. <ul><li>Based on investor and market evaluation, form optimal asset allocation </li></ul><ul><li>Asset allocation = proportion of funds invested in general asset classes </li></ul><ul><li>Asset classes may be very general… </li></ul><ul><ul><ul><li>stocks/bonds/cash equivalents </li></ul></ul></ul><ul><ul><ul><li>Safety/income /growth </li></ul></ul></ul><ul><li>or more specific… </li></ul><ul><ul><ul><li>by equity sector, long bonds, short bonds </li></ul></ul></ul><ul><ul><ul><li>Canadian equities/foreign equities/Canadian bonds/foreign bonds </li></ul></ul></ul>Investment Strategy & Asset Allocation
  15. 15. <ul><li>asset allocation often done through optimization in mean-variance framework </li></ul><ul><li>many people consider asset allocation the most important decision (more important than actual bonds/stocks chosen) </li></ul><ul><ul><li>Brinson, Hood and Beebower (1986) </li></ul></ul><ul><ul><li>Asset allocation explains 93.6% of return variation over time </li></ul></ul><ul><li>allocation may be Strategic Asset Allocation (only change allocation when investor changes) or Tactical Asset Allocation (market timing, changing allocation as markets change) </li></ul>Investment Strategy & Asset Allocation
  16. 16. <ul><li>after asset allocation decision, must chose specific securities (e.g. stocks, bonds, etc.) to make up portfolio </li></ul><ul><ul><ul><li>active versus passive investing may be used here </li></ul></ul></ul><ul><ul><ul><li>mean-variance optimal portfolio might be used to find best portfolio of stocks, of bonds, etc. </li></ul></ul></ul>Investment Strategy & Asset Allocation
  17. 17. <ul><li>monitor market conditions, possibly make changes as warranted (this would be Tactical Asset Allocation) </li></ul><ul><ul><ul><li>trade-off: trading too frequently (high transaction costs) versus not trading frequently enough (holding on to bad positions) </li></ul></ul></ul><ul><ul><ul><li>Strategic Asset Allocation would only change if long term expectations about markets change </li></ul></ul></ul><ul><li>monitor changes in client (objectives, constraints), make changes to asset allocation as warranted </li></ul><ul><ul><ul><li>this is important step </li></ul></ul></ul>Market, Investor & Portfolio Monitored
  18. 18. Institutional vs Individual Investors <ul><li>There are some key differences between individuals and institutions in terms of forming investment objectives and constraints </li></ul><ul><li>Institutions typically more quantitative in evaluating risk (e.g. use standard deviation) </li></ul><ul><li>Individuals defined by their personalities, while institutional portfolios should be evaluated in terms of needs/constraints of beneficiaries of portfolio </li></ul><ul><li>General goals are important for individuals, while institutions tend to be more precise. </li></ul><ul><li>Institutions often subject to legal and regulatory constraints on what they can invest in. </li></ul><ul><li>Taxes important for individuals, but often institutions are not taxed. </li></ul>