Investment Policy Statement Otto Khatamov

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

1. Client needs: Investment policy statement Focus: Investors 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 investors needs at minimum risk levels 4. Client/Portfolio manager: Feedback loop Monitor and update investor needs, environmental conditions, evaluate portfolio performance

A. The preliminaries i.Basic needs ii.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 preliminaries Rise and fall of personal Net worth over the lifetime Accumulation phase Long-term: retirement, childerns needs Short-term: House, car Consolidation phase Long-term: retirement Short-term: vacations, childerns needs Spending phase Long-term: estate planning Short-term: lifestyle needs gifts

A. The preliminaries Benefits from investing early

A. The preliminaries Rise and fall of personal Net worth over the lifetime Accumulation phase Long-term: retirement, childerns needs Short-term: House, car Consolidation phase Long-term: retirement Short-term: vacations, childerns 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: Investors willingness to accept risk Investors ability to accept risk

B. Inputs to the investment policy statement Investment objectives Suggested initial asset allocation by investment banks (i.e. TRowePrice.com) Time Horizon Risk Tolerance 3-5 Years6-10 Years11+ Years High 20% cash 40% bonds 40% stocks 10% cash 30% bonds 60% stocks 100% stocks Moderate 30% cash 50% bonds 40% stocks 20% cash 40% bonds 40% stocks 20% bonds 80% stocks Low 100% cash 30% cash 50% bonds 20% stocks 10% cash 30% bonds 60% stocks

B. Inputs to the investment policy statement Investment objectives 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 returns and Lehman Brothers long-term and intermediate indexes for 1996 and later returns. SeriesGeometric AverageArithmetic averageStandard 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 Bills3.78%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.

B. Inputs to the investment policy statement 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)

B. Inputs to the investment policy statement Investment objectives 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.

B. Inputs to the investment policy statement Investment objectives 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.

B. Inputs to the investment policy statement Investment objectives: Individuals versus institutions Type of InvestorReturn requirementsRisk Tolerance IndividualDepends on stage of life, circumstances and obligations Variable Mutual fundsVariable Pension fundsAssumed actuarial rateDepends on proximity of payouts Endowment fundsReturn to cover annual spending, investment expenses, and expected inflation Generally conservative Life insurance companiesReturn to meet expenses and profit objectives Conservative due to regulations Non-life insuranceFinancial needs and competitionConservative due to regulation BanksCost of capitalVariable

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

B. Inputs to the investment policy statement Investment constraints 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

B. Inputs to the investment policy statement Investment constraints Tax concerns Taxable income from interest, dividends or rents are taxable at the investors 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

B. Inputs to the investment policy statement Investment constraints 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

B. Inputs to the investment policy statement Investment constraints 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 institutions Type of InvestorLiquidityHorizonRegulationsTaxes IndividualVariableLife cycleFewVariable Mutual fundsHighVariableFewNone Pension fundsYoung, low; mature, high LongYesNone Endowment fundsLowLongFewNone Life insurance companies LowLongYes Non-life insuranceHighShortFewYes BanksHighShortChangingYes

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

Investment Policy Statement 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