Question

AN OVERVIEW OF THE INVESTMENT POLICY STATEMENT 

One of the most important and overlooked principles of investments is the construction of an investment policy statement. Although most investment textbooks do an adequate job of teaching such traditional topics as financial statement analysis, valuation and market efficiency, only a handful of texts cover investment policy [Reilly and Norton,1999] or [Strong, 2006]. The topic of investment policy is considered so important to the CFA Institute that numerous readings on this subject are included in their Chartered Financial Analyst program.Essentially, the investment policy statement helps to assist the money manager by providing the objectives and constraints that the investor faces in constructing his/her investment portfolio. These objectives and constraints allow the money manager to tailor the portfolio to the individuals’ specific needs. The investment policy statement also serves as a contract between the money manager and the client and protects both by laying out the investment action to be taken. The objectives of an investor are the starting point for preparing a sound financial plan.The objectives need to clearly outline realistic goals for the investor. Objectives such as making as much money as possible are too broad to allow a money manager or the investor to produce a sound financial plan. In fact, broad objectives like this may actually lead a money manager to invest the client's funds inappropriately. The objectives consistof the return and risk preferences of the investor. For example, the goal of a recent college graduate to become a millionaire by age 30 may be unrealistic, given this person’s $50,000 per year job. However, the goal of saving a sufficient amount of moneyto be able to retire at age 55 may be attainable with a sound financial plan.In addition to the objectives, each investor will face a number of constraints that will help determine the appropriate assets to be included in his or her portfolio. Constraints that the investor will face include his time horizon,risk tolerance, return requirements, regulatory and legal considerations,liquidity needs, tax circumstances, and any unique preferences or circumstances.AN OVERVIEW OF ASSET ALLOCATION Many financial experts consider the asset allocation decision to be the most critical decision an investor will face. Although many individuals consider the ability to identify the next Microsoft, Starbucks or Google the key to investment success, asset allocationplays a much more important role in the performance of an investment portfolio. In a now classic article in the Financial Analysts Journal, [Brinson, Hood and Beebower, 1986] showed that 93.6 percent of the total plan return could be explained by the plan’s asset allocation. Asset allocation draws on the tools of portfolio theory and shows how investors should combine different financial assets to form the best possible portfolio to achieve their objectives. However, unlike modern portfolio theory, wherethere are numerous restrictive assumptions, such as homogeneous expectations, no transaction costs and no taxes, which leads to an optimal portfolio, there may be many “best” portfolios consistent with the investor’s circumstances. The longer an investor’s time horizon and the greater the investor’s tolerance for risk, the more the portfolio can be tilted toward higher risk, higher return assets. Many investors mistakenly assume that the converse investors with shorter time horizons and lower tolerances for risk should hold only low risk assets-is also true. There are two reasons why individuals with low tolerances for risk can, and arguably, should hold some high risk assets. First, low return assets increase the risk that the individual will lose purchasing power through increases in the price level. Second, portfolio theory tells us that it may be possible to combine high-risk assets in a portfolio and increase the return of the portfolio while actually reducing the total risk of the portfolio.

QUESTION ONE (20)

1.1 The investment process includes asset allocation and security selection. Define and explain the terms:-assetallocation and security selection(use examples)(6)

1.2 Identify the constraints mentioned in the case study helps to determine the appropriate assets to be included in an investor’s portfolio. Discuss how these constraints affect the types of assets included in an investment portfolio?

Answer 1

Answer 1.1:

Asset allocation and security selection are two major concern of preparing a portfolio.

Asset allocation is the method of dividing the whole investment in different asset categories. It reduces the risk of investor and help by balancing the portfolio. Different Asset categories can be such as Stocks, bonds, Equity, cash and mutual funds .The aim of asset allocation is to reduce the risk of investment but diversifying the portfolio. A good asset allocation can reduce the risk and increase the returns .we can manage asset allocation differently for every investor like we can divide it in equity, stocks, and mutual funds and keep some portion in cash.

Security selection is the process of choosing specific securities within a specific asset class .it also help to balance the investor’s portfolio and reduce risk. A good security selection creates wealth and keeps the portfolio balance during the market swings. Securities choosen in a portfolio can be diversified so that the effect of market swings does not affect the investment much. To make a good portfolio a manager can choose securities from different sectors like pharma, information technology, manufacturing, automobile, banking etc. A good security selection must be diversified so that it can balance the risk and increase the returns.

Answer 1.2:

Constraints help money managers to identify investor’s needs and help to create a suitable portfolio based on his constraints. Constraints that an investor may face include his time horizon, risk tolerance, tax concern and return requirements.

Every investor has his goals which he set in his mind at the time of creating an investment portfolio. The portfolio managers have to identify constraints in his investment oath and have to create a portfolio bases on particular clients financial goals. The effect of main constraints discussed in the case study is as following:

Time Horizon:

Time is a major constraint and it can be managed using high and low risk assets in portfolio. It develop a predefined timeline to fulfill various financial needs and differ for every individual. Time horizon can be long term or short term and a portfolio is designed to understand the investor’s time horizon.

Risk Tolerance:

Risk bearing capacity is also another constraint for a investor and a portfolio manager have to understood his clients risk bearing capacity and then prepare his portfolio. For long term investors it can be low but the risk for short term investors is high.

Tax constraint:

Investors do not want to reduce his returns by giving much tax so he prefers a portfolio in which tax constraints are low. After tax returns are the returns a investor get so a portfolio must be included this constraint.

Return Requirements:

Return requirement are a major constraint as every investors return requirements are different ie. Someone wants to invest for higher study, someone for marriage and house and someone for retirement benefits, so this constraint must be kept in consideration when preparing an investor’s portfolio.