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• Investment management process


  • Planning
  • Execution
  • Feedback
• Investment policy statement (IPS)


  • Addresses objectives, constraints, duties, performance measures, and other key considerations
• Components of the investment policy statement

  • Brief client description
  • Purpose of establishing policies and guidelines
  • Duties and investment responsibilities of parties involved
  • Statement of investment goals, objectives, and constraints
  • Schedule for review of investment performance and the IPS
  • Performance measures and benchmarks
  • Considerations in developing strategic asset allocation
  • Investment strategies and investment styles
  • Guidelines for rebalancing
• Objectives


  • Return requirements
  • Risk tolerance
  • Horizon
• Constraints


  • Liquidity
  • Regulations
  • Taxes
  • Unique needs (ethical concerns, hedging, age, wealth)
• Personal trust


  An interest in an asset held by a trustee for the benefit of another person
• Mutual fund


  A firm pooling and managing funds of investors
• Personal trust managers are expected to invest with more risk aversion than individual investors due to fiduciary responsibility
• Certain asset classes and strategies are ruled out for personal trusts, such as options, futures, short-selling, and buying on margin
• Risk tolerance quizzes


  Help people determine whether they are conservative, moderate, or aggressive investors
• Firms that offer risk tolerance quizzes

  • Merrill Lynch
  • T. Rowe Price Associates Inc.
  • Zurich Group Inc.'s Scudder Kemper Investments Inc.
  • Vanguard Group
• Risk questionnaires


  • Include 7 to 10 questions about a person's investing experience, financial security, and tendency to make risky or conservative choices
• Benefit of risk tolerance questionnaires

  They are an objective resource people can use to get at least a rough idea of their risk tolerance
• It is impossible for someone to assess their risk tolerance alone
• Assessing risk tolerance


  1. Step 1: Take a risk tolerance questionnaire

  2. Step 2: Ask yourself difficult questions like how much you can stand to lose over the long term
• Most people rank as middle-of-the-road risk-takers, with only about 10% to 15% being aggressive
• Investor responses to a 20% drop in investment price


  • Sell to avoid further worry and try something else
  • Do nothing and wait for the investment to come back
  • Buy more as it was a good investment before and now it's cheap
• Investor responses to a 20% drop in investment price with different investment time horizons

  • 5 years away: Sell
  • 5 years away: Do nothing
  • 5 years away: Buy more
  • 15 years away: Sell
  • 15 years away: Do nothing
  • 15 years away: Buy more
  • 30 years away: Sell
  • 30 years away: Do nothing
  • 30 years away: Buy more
• Investor responses to a 25% jump in investment price

  • Sell it and lock in gains
  • Stay put and hope for more gain
  • Buy more as it could go higher
• Risk tolerance score


  • 9-14 points: Conservative investor
  • 15-21 points: Moderate investor
  • 22-27 points: Aggressive investor
• The return requirement and risk tolerance across mutual funds are highly variable because funds segment the investor market
• Mutual fund objectives are spelled out in the prospectus
• Defined contribution pension plans

  Savings accounts established by the firm for its employees, where the employee bears the investment risk
• Defined benefit pension plans

  The employer has an obligation to provide a specified annual retirement benefit, and the employer bears the investment risk
• Pension fund asset allocation

  1. Pension fund sponsor appoints a manager

  2. Pension actuary signs off on the expected rate of return used to compute the present value of fund obligations
• If a pension fund's actual rate of return exceeds the actuarial assumed rate

  The firm's shareholders reap an unanticipated gain
• If a pension fund's actual rate of return falls short of the assumed rate

  The firm will have to increase future contributions
• Life insurance companies


  Invest to hedge their liabilities defined by the policies they write
• Whole-life insurance policy


  Combines a death benefit with a savings plan that provides for a gradual buildup of cash value
• Term insurance


  Provides death benefits only, with no buildup of cash value
• Variable life policy


  Entitles the insured to a fixed death benefit plus a cash value that can be invested in the policyholder's choice of mutual funds
• Universal life policy


  Allows policyholders to increase or reduce the insurance premium or the death benefit according to their changing needs, and the interest rate on the cash value component changes with market interest rates
• Non-life insurance companies


  Are conservative in their attitude toward risk and typically hedge predictable long-term liabilities with bonds
• Banks


  Try to match the risk of assets to liabilities while earning a profitable spread between lending and borrowing rates
• Most long-term fixed-rate mortgages today are securitized into pass-through certificates and held as securities by institutional investors
• Endowment funds


  Held by organizations chartered to use their money for specific non-profit purposes, financed by gifts from sponsors and managed by educational, cultural, and charitable organizations or independent foundations
• Higher-risk strategies


  Elicit higher capital requirements as well as the possibility of greater regulatory interference in the bank's affairs
• Most long-term fixed-rate mortgages today are securitized into pass-through certificates and held as securities in the portfolios of mutual funds, pension funds, and other institutional investors
• Mortgage originators


  • Typically sell a portion of the mortgages they originate to pass-through agencies like Fannie Mae or Freddie Mac rather than holding them in a portfolio
  • Earn their profits on mortgage origination and servicing fees
• The trend away from maintaining portfolio holdings of long-term mortgages has reduced interest rate risk