Investment Policy Statement Otto Khatamov. Income ConsumptionSavings Investment How to manage investments in assets (i.e. stocks, bonds etc.) to meet

Investment Policy Statement

Otto Khatamov

Income

Consumption Savings

Investment

How to manage investments in assets (i.e. stocks, bonds etc.) to meet specified investment goals?

1. Client needs: Investment policy statement• Focus: Investor’s short-term and long-term needs,

expectations

2. Portfolio manager: Examine current and projected financial, economic, political, and social conditions• Focus: Short-term and intermediate-term expected conditions

to use in constructing a specific portfolio

3. Portfolio manager: Implement the plan by constructing the portfolio• Focus: Meet the investor’s needs at minimum risk levels

4. Client/Portfolio manager: Feedback loop• Monitor and update investor needs, environmental conditions,

evaluate portfolio performance

A. The preliminariesi. Basic needsii. Investment and life cycle net worth

B. Two important components of the investment policy statement

i. Investment objectives Individuals versus institutions

ii. Investment constraints Individuals versus institutions

C. Investment Policy Statement: In detail

A. The preliminaries◦ Investment funds after the satisfaction of basic

needs (i.e. living cost): Insurance: Life insurance, Health insurance,

Automobile and home insurance. Cash reserves (i.e. six months’ living expenses):

Emergencies, Job layoffs, Investment opportunities.◦ Investment needs and the life cycle net worth:

Accumulation phase Consolidation phase Graphically Spending phase

A. The preliminariesRise and fall of personal Net worth over the lifetime

Accumulation phase

Long-term: retirement, childern’s needs

Short-term:House, car

Consolidation phase

Long-term: retirement

Short-term: vacations, childern’s needs

Spending phase

Long-term: estate planning

Short-term: lifestyle needs gifts

A. The preliminariesBenefits from investing early

The Future Value of an Initial £10000 Investment

The Future Value of Investing £2000 Annually

Interest Rate 7%20 Years £38696.84 £81990.9830 Years £76122.55 £188921.5740 Years £149744.58 £399270.22Interest Rate 8%20 Years £46609.57 £91523.9330 Years £100626.57 £226566.4240 Years £217245.21 £518113.04

A. The preliminariesRise and fall of personal Net worth over the lifetime

Accumulation phase

Long-term: retirement, childern’s needs

Short-term:House, car

Consolidation phase

Long-term: retirement

Short-term: vacations, childern’s needs

Spending phase

Long-term: estate planning

Short-term: lifestyle needs gifts

B. Inputs to the investment policy statement◦ Investment objectives

Risk return relationship (pyramid game i.e. Ponzi, Afinsa etc.)

What is risk? Risk denotes the probability distribution of possible economic outcomes (danger vs opportunity).

Absolute vs relative risk Risk tolerance:

Investor’s willingness to accept risk Investor’s ability to accept risk


Suggested initial asset allocation by investment banks (i.e. TRowePrice.com)

Time Horizon

Risk Toleran

ce

3-5 Years6-10 Years

11+ Years

High

20% cash40% bonds40% stocks


100% stocks

Moderate



20% bonds80% stocks

Low100% cash




The historical record: Bills, bonds and stocks

Source: BKM Chapter 5 – Sources: Returns on T-bills, large and small stocks – CRSP, T-bonds - RSP for 1926-1995 returns and Lehman Brothers long-term and intermediate indexes for 1996 and later returns.

SeriesGeometric Average

Arithmetic average

Standard Deviation

Small-Company Stocks

11.64% 17.74% 39.30%

Large-Company Stocks

10.01% 12.04% 20.55%

Long-Term Government Bonds

5.38% 5.68% 8.24%

US Treasury Bills 3.78% 3.82% 3.18%

B. Inputs to the investment policy statement

◦ Investment objectives: Question Based on the historical record over the long-run,

stocks outperformed bonds and bills. Why not invest 100% in stocks?

C., Asness, 1996, Why not 100% Equities, The Journal of Portfolio Management.


◦ Investment objectives What is an appropriate investment objective for a

25-year old and a 65-year old investor? Basic needs Capital preservation/appreciation Risk tolerance (assume moderate)


25-year old investor Basic needs: Steady job, insurance coverage, cash

reserve Capital preservation/appreciation: Given the age

capital appreciation is more appropriate Risk tolerance (moderate): Assuming long horizon she

must invest in risky assets (i.e. riskier than NYSE index). Equity exposure should range from 70% to 90% and the remaining funds should be invested in bonds or short-term notes.


65-year old investor Basic needs: Steady job, insurance coverage, cash

reserve Capital preservation/appreciation: Given the age

capital preservation is more appropriate Risk tolerance (moderate): Assuming short horizon

and capital preservation she must invest around 50% in bonds and 30% in short-term notes. The remaining should be invested in high-quality stocks (i.e. risk similar to S&P 500). This strategy protects from inflation and provides income rather than capital gains.


◦ Investment objectives: Individuals versus institutionsType of Investor Return requirements Risk Tolerance

Individual Depends on stage of life, circumstances and obligations

Variable

Mutual funds Variable Variable

Pension funds Assumed actuarial rate Depends on proximity of payouts

Endowment funds Return to cover annual spending, investment expenses,

and expected inflation

Generally conservative

Life insurance companies Return to meet expenses and profit objectives

Conservative due to regulations

Non-life insurance Financial needs and competition Conservative due to regulation

Banks Cost of capital Variable

B. Inputs to the investment policy statement◦ Investment constraints

Liquidity needs Liquid assets

Treasury bills vs real estate Short-term needs

Car, house and college tuition fees

25-year old investor Little need for liquidity

Possibility for unemployment or honeymoon expense 65-year old investor

Greater need for liquidity Lifestyle needs for expenses


Time horizon Long investment horizon generally need less liquidity

and can tolerate greater risk

25-year old investor Due to life expectancies has longer investment time

horizon 65-year old investor

Due to life expectancies has shorter investment time horizon


Tax concerns Taxable income from interest, dividends or rents are

taxable at the investor’s marginal rate (i.e. 10%-40%) Capital gains are taxed differently (i.e. 15%). Capital gains are taxed when they are realised (i.e. asset is

sold) whereas income is taxed when it is received International investments

25-year old vs 65-year old investor Depending on their tax bracket may have preferences for

different assets i.e. tax-exempt income or tax-deferred plans


Legal and regulatory factors Fund withdrawal from a 401(k) plan before the age of

59.5 are taxable to an additional 10% penalty

25-year old vs 65-year old investor Similar concerns for both investors


Unique needs and preferences Refers to idiosyncratic concerns of each investor

Avoid investments in tobacco companies or environmentally harmful products

Expertise of the portfolio manager

25-year old vs 65-year old investor Depends on each individual

B. Inputs to the investment policy statement◦ Investment constraints: Individuals versus

institutionsType of Investor Liquidity Horizon Regulations Taxes

Individual Variable Life cycle Few Variable

Mutual funds High Variable Few None

Pension funds Young, low; mature, high

Long Yes None

Endowment funds Low Long Few None

Life insurance companies

Low Long Yes Yes

Non-life insurance High Short Few Yes

Banks High Short Changing Yes

c. Investment policy statement: In detail◦ Components of investment policy statement

Brief description of the client The duties and investment responsibilities of parties

involved The statement of investment objectives/constraints The schedule for review of both the investment

performance and the investment policy statement Performance measures and benchmarks Investment strategies/style Guidelines for rebalancing the portfolio based on

feedback

c. Investment policy statement: In detail◦ Importance of investment policy statement

Define realistic investor goals (i.e. objectives, constraints, education purposes)

Standards for evaluating portfolio performance (i.e. benchmark portfolio)

Performance vs investment policy statement Other benefits

Protection against inappropriate behavior from entrenched managers

• Maginn, Tuttle, Pinto and McLeavey, Chapters 1 and 2

• Reilly and Brown, Chapter 2• Bodie, Kane and Marcus, Chapter 26

Documents

Investment Policy Statement Otto Khatamov. Income ConsumptionSavings Investment How to manage investments in assets (i.e. stocks, bonds etc.) to meet