Professional Documents
Culture Documents
Outline
Introduction Why setting objectives can be difficult Portfolio objectives The importance of primary and secondary objectives Other factors to consider in establishing objectives Portfolio dedication
Prof. Rushen Chahal 3
Introduction
Setting objectives is important for every person and institution that uses financial planning
Too many investors have a casual attitude It is easy to be imprecise in communicating with the portfolio manager Gallup survey finds 39% believe stocks will return 15% annually for next ten year
Introduction (cont d)
Pension and Investments article states importance of setting portfolio objectives:
Two factors contribute to a sponsor s successful investment program:
Suitable investment objectives and policy Successful selection of the investment managers to implement policy
Semantics
Growth, income, return on investment, and risk mean different things to different people
E.g., a savings account provides income only; it has no growth potential There must be a clear understanding of the terms when entrusting money to a fund manager
Semantics (cont d)
Interpretation of Principal and income
One interpretation is that principal is the original amount (accumulated interest is not included) Another interpretation is that accumulated interest is included in principal following the initial year
Indecision
The client s inability to make a decision E.g., a bank customer wants to have interest compounded but have the interest send home each month
Subjectivity
Investing is both an art and a science
There are inevitably shades of gray that involve subjective judgments E.g., which stocks are considered growth and which are considered income?
10
Multiple Beneficiaries
Investment portfolios often have more than one beneficiary
E.g., an endowment fund has a perpetual life
11
12
13
Portfolio Objectives
Preconditions Traditional portfolio objectives Tax-free income generation Portfolio objectives and expected utility
14
Preconditions
Questions to be answered before setting objectives and formulating strategy:
Assess the existing situation
What are the current needs of the beneficiary? What is the investment horizon? Are there special liquidity needs? Are there ethical investing concerns established by the fund s owner or overseer?
15
16
Stability of Principal
Emphasis is on preserving the original value of the fund
The most conservative portfolio objective Will generate the most modest return over the long run
17
18
19
Income
No specific proscription against periodic declines in principal value
E.g., a Treasury note may experience a decline in value if interest rates rise, but the investor will not experience a loss of he holds the note to maturity
20
Income (cont d)
Appropriate investment vehicles:
Corporate bonds Government bonds Government agency securities Preferred stock Common stock
21
Growth of Income
Benefits from time value of money
Sacrifices some current return for some purchasing power protection
22
23
24
25
26
Capital Appreciation
The goal is for the portfolio to grow in value and not to generate income Appropriate for investors who have no income needs
27
The investor can defer taxes for many years by successful long-term growth stock investing
28
29
30
29.28 20 ! (1 R ) 4 R ! 10.00%
Prof. Rushen Chahal 32
26.68 20 ! (1 R ) 4 R ! 7.47%
Prof. Rushen Chahal 33
Invest directly in municipal bonds for an income strategy Invest in a mix of municipal bonds and common stock for a growth-of-income strategy
37
38
39
40
Introduction
The secondary objective indicates what is next in importance after specification of the primary objective
E.g., an investor chose income as the primary objective, but:
Does not want to take a lot of risk with the invested money (stability of principal) Wants to keep up with inflation (growth of income)
41
42
43
Inconsistent Objectives
Certain primary/secondary combinations are incompatible
Primary: stability of principal Secondary: capital appreciation
I want no chance of a loss, but I do want capital gains
44
Infrequent Objectives
Certain primary/secondary combinations are infrequent
Primary: capital appreciation Secondary: stability of principal
Could invest in low coupon bonds selling at a substantial discount from par and hold the bond to maturity
45
Portfolio Splitting
A fund manager receives instructions that require that the portfolio be managed in more than one part
E.g., endowment funds
Components will have different objectives A more convenient way of administering the fund than trying to establish a single, overall objective
46
Liquidity
Liquidity is a measure of the ease with which something can be converted to cash Clients may desire some liquidity
Options: invest a portion of the portfolio in money market mutual funds or cash management accounts at brokerage firms with check-writing privileges
47
48
Portfolio Dedication
Introduction Cash matching Duration matching
50
Introduction
Portfolio dedication (liability funding) involves managing an asset portfolio so that it services the requirements of a corresponding liability or portfolio of liabilities
Overlays the primary and secondary investment objectives The two principal methods are cash matching and duration matching
51
Cash Matching
The most common form of portfolio dedication A manager assembles a portfolio of bonds whose cash flows match as nearly as possible the requirements of a particular liability
52
Duration Matching
Involves constructing a portfolio of assets that pays the bills associated with a liability or stream of liabilities Duration is a measure of interest rate risk
The higher the duration, the greater the fluctuation in the price of a bond due to interest rate changes
Prof. Rushen Chahal 53
54
55