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Lecture Presentation Softwareto accompany
Investment Analysis and Portfolio Management
Seve nth Editionby
Frank K. R e illy & Ke ith C. Brown
Chapter 2
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Individual InvestorLife Cycle
Accumulation phase early to middleyears of working career Consolidation phase past midpoint of careers. Earnings greater thanexpenses
Spending/Gifting phase begins after retirement
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Individual Investor Life Cycle
25 35 45 55 65 75
N et Worth
Ag e
A ccumulationP h ase
Long-term:Retirement
Ch ildrenscollege
S h ort-term:HouseC ar
C onsolidation P h ase
Long-term:Retirement
S h ort-term:
Vacations
Ch ildrens C ollege
Spending P h aseGifting P h ase
Long-term:Estate
Planning
S h ort-term:Lifestyle
Needs Gifts
Exhibit 2.1
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Life Cycle Investment Goals
Near-term, high-priority goals
Long-term, high-priority goals
Lower-priority goals
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Th e Portfolio Management Process
1 . Policy statement - Focus: Investors short-term and long-term needs, familiarity with capital market history, andexpectations
2. Examine current and project financial, economic, political, and social conditions - Focus: Short-term andintermediate-term expected conditions to use inconstructing a specific portfolio
3. Implement the plan by constructing the portfolio - Focus:Meet the investors needs at the minimum risk levels
4. Feedback loop: Monitor and update investor needs,environmental conditions, portfolio performance
Exhibit 2.2
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Th e Portfolio Management Process
1 . Policy statement
specifies investment goals andacceptable risk levels
should be reviewed periodically
guides all investment decisions
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Th e Portfolio Management Process
2. Study current financial and
economic conditions and forecastfuture trends determine strategies to meet goals
requires monitoring and updating
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Th e Portfolio Management Process
3. Construct the portfolio
allocate available funds to minimizeinvestors risks and meet investmentgoals
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Th e Portfolio Management Process
4. Monitor and update
evaluate portfolio performance Monitor investors needs and marketconditions
revise policy statement as needed modify investment strategy
accordingly
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The Need For A Policy Statement
Helps investors understand their ownneeds, objectives, and investment
constraintsSets standards for evaluating portfolio performanceReduces the possibility of inappropriate behavior on the part of the portfolio manager
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Investment ObjectivesRisk ToleranceAbsolute or relative percentagereturnGeneral goals
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Investment ObjectivesGeneral GoalsCapital preservation
minimize risk of real lossCapital appreciation Growth of the portfolio in real terms to meet
future needCurrent income Focus is in generating income rather than
capital gains
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Investment ObjectivesGeneral GoalsTotal return Increase portfolio value by capital gains and by
reinvesting current income Maintain moderate risk exposure
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Investment ConstraintsLiquidity needs Vary between investors depending upon age,
employment, tax status, etc.Time horizon Influences liquidity needs and risk tolerance
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Investment ConstraintsT ax concerns Capital gains or losses taxed differently from
income Unrealized capital gain reflect priceappreciation of currently held assets that havenot yet been sold
Realized capital gain when the asset has beensold at a profit Trade-off between taxes and diversification
tax consequences of selling company stock for
diversification purposes
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Investment ConstraintsTax concerns (continued) interest on municipal bonds exempt from
federal income tax and from state of issue interest on federal securities exempt from state
income tax contributions to an IRA may qualify as
deductible from taxable income tax deferral considerations - compounding
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Legal and Regulatory FactorsLimitations or penalties on withdrawalsFiduciary responsibilities -
prudent man ruleInvestment laws prohibit insider trading
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Unique Needs and PreferencesPersonal preferences such as socially conscious
investments could influence investment choiceTime constraints or lack of expertise for managingthe portfolio may require professionalmanagementLarge investment in employers stock may requireconsideration of diversification needsInstitutional investors needs
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Constructing th
e Policy StatementObjectives - risk and returnConstraints - liquidity, time horizon, tax
factors, legal and regulatory constraints, andunique needs and preferencesDeveloping a plan depends onunderstanding the relationship between risk and return and the the importance of diversification
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Th e Importanceof Asset Allocation
An investment strategy is based on four decisions What asset classes to consider for investment What normal or policy weights to assign to each
eligible class Determining the allowable allocation ranges
based on policy weights What specific securities to purchase for the
portfolio
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Th e Importanceof Asset Allocation
According to research studies, most (85% to95%) of the overall investment return is dueto the first two decisions, not the selectionof individual investments
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Returns and Risk of DifferentAsset Classes
Historically, small company stocks havegenerated the highest returns. But the
volatility of returns have been the highesttooInflation and taxes have a major impact on
returnsReturns on Treasury Bills have barely kept pace with inflation
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Asset Allocation SummaryPolicy statement determines types of assetsto include in portfolio
Asset allocation determines portfolio returnmore than stock selectionOver long time periods, sizable allocation toequity will improve resultsRisk of a strategy depends on the investorsgoals and time horizon