Contemporary Investments: Chapter 20

Chapter 20 BUILDING AND MANAGING AN

INVESTMENTPORTFOLIO• What is the process of building and

managing an investment portfolio?

• How is an investment policy developed?

• How do capital market assumptions affect the investment process?

• What is asset allocation?

• What does monitoring a portfolio involve?

Contemporary Investments: Chapter 20

Constructing and managing an investment portfolio

• Investment policy

– Investment objectives

– Investment constraints

– Preferences

• Formulating financial market expectations

Contemporary Investments: Chapter 20

Constructing and managing an investment portfolio-Cont.

• Portfolio construction

– Strategic asset allocation

– Tactical asset allocation

• Portfolio monitoring

Contemporary Investments: Chapter 20

Figure 20.1 – An Outline of Portfolio Construction and Management Process

Contemporary Investments: Chapter 20

Developing an investment policy• Differences between individuals and

institutions

– Time horizon

– Changes in investor characteristics

– Risk and behavior

– Reasons for investing

– Regulatory and legal constraints

– Taxes

Contemporary Investments: Chapter 20

Formulating investment objectives

• The three objectives– Growth in capital

– Preservation of capital

– Current income

• Prioritizing these objectives

• Real life examples– Mark’s retirement

– Kim’s daughter’s college education

Contemporary Investments: Chapter 20

Constraints

• Definition

• Time horizon

• Liquidity needs

Contemporary Investments: Chapter 20

Constraints –Cont.

• Taxes– Capital gains are taxed at a lower rate than

ordinary income

– Only realized capital gains are taxed

– Retirement plans offer substantial tax benefits

– Estate tax rates are higher than income tax rates

• Regulatory and legal constraints

• Special needs, circumstances and goals

Contemporary Investments: Chapter 20

Financial market expectations

• Macro-expectations– Based on the historical record

– Stocks have outperformed bonds and cash investments by substantial margins

– Stock returns have exhibited much more year-to-year variability than other investment returns

– Much of the variability in stock returns has disappeared over longer holding periods

Contemporary Investments: Chapter 20

Figure 20.2 – The Growth of a $1,000 Investment, 1925-2001

Contemporary Investments: Chapter 20

Some observations

• Stocks are better long-term investments than other financial assets

• Long-term returns are far more predictable (or less uncertain) than short-term returns

• The historical record is just that, a record of what happened

Contemporary Investments: Chapter 20

Financial market expectations - Cont.

• Micro-expectations

– Definition

– Based on the historical record

–Micro-expectations are more difficult

Contemporary Investments: Chapter 20

Figure 20.3 – Returns from Large- and Small-Company Stocks

Contemporary Investments: Chapter 20

Asset allocation

• Types of asset allocation decisions

– Strategic asset allocation

• Based on objectives, return requirements, time horizon and risk preferences

• Role of macro and micro-expectations

– Tactical asset allocation

–Which is more important

Contemporary Investments: Chapter 20

Asset allocation - Cont.

– Life cycle approach to asset allocation

– Diversification and portfolio optimization

Contemporary Investments: Chapter 20

Figure 20.4 – A Simple Model of

Asset Allocation

Contemporary Investments: Chapter 20

Investment Insight – Some Suggested Retirement Portfolios

Contemporary Investments: Chapter 20

Figure 20.5 – Efficient Frontier: Combinations of Large Stocks, Small Stocks, Bonds, and Bills

Contemporary Investments: Chapter 20

Monitoring portfolios

• Active versus passive management

• Changes in investor circumstances– Getting older

– Increases in wealth

– Change in family status

• Rebalancing

• Performance measures and evaluation