CHAPTER 26

Investors and the Investment Process

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Overview of the Investment Process

Specify objectives Identify constraints Formulate an investment policy Monitor performance Reevaluate and modify portfolio as

determined from monitoring

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Specifying Objectives: Individual Investors

Balance risk and return

Life Cycle is critical to the process of determining the 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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Specifying Objectives: Personal Trusts and Mutual

Funds Personal Trusts

– Determined by the individual for whom the funds are being managed

Mutual Funds– Varies with type of fund– Detailed in the prospectus

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Specifying Objectives: Pension Funds and

Endowments

Pension Funds– Defined contribution - shifted to the individual– Defined benefit - depends on average time to

retirement of individuals Endowment Funds

– Gifts to nonprofits are invested– Funds from the endowment used by the nonprofit

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Specifying Objectives: Insurance Companies

Life Companies– Investments are hedged against potential

claims of policy holders Non-Life Companies

– Invest premiums not paid back to policyholders for loss

– Hedge against potential claims

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Specify Objectives: Banks Sources of funds: deposits and

borrowed funds Investment of funds: predominately in

loans and fixed income securities Active in the securitized loan and asset

markets Not active in equity except in the Trust

Function

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Investor ConstraintsLiquidity - speed and ease with which as

asset can be converted into cashInvestment Horizon - the planned

liquidation dateRegulations - specific regulations that may

apply to the investorPrudent Man RuleMutual Fund DiversificationCharitable contribution limits

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Investor Constraints

Tax Considerations - special considerations related to tax position of the investor

Unique Needs- special considerations related to the underlying investors

Diversification requirements related to employment

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Investment Policy: Asset Allocation Decision

Individual - depends on life cycle

Younger Higher equity 75% Lower safe assets 25%

Older Lower equity 40% Higher safe assets 60%

Institutional - depends on objectivesExample - an all stock mutual fund would want nearly 100% in stock Sector or Region allocations

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Investment Policy: Active or Passive

Active

Trying to secure better than average performance

Must balance returns and costs

Passive

Trying to get average returns rather than do better than the market

Mix of Passive and Active