The Portfolio Management Process (From Ch. 2) Investment Analysis and Portfolio Management Sixth Edition by Frank K. Reilly & Keith C. Brown The Portfolio Management Process (From Ch. 2)

The Portfolio Management Process Figure 2.2 The Portfolio Management Process 1. Policy statement - Focus: Investor’s short-term and long-term needs, familiarity with capital market history, and expectations 2. Examine current and project financial, economic, political, and social conditions - Focus: Short-term and intermediate-term expected conditions to use in constructing a specific portfolio 3. Implement the plan by constructing the portfolio - Focus: Meet the investor’s needs at the minimum risk levels 4. Feedback loop: Monitor and update investor needs, environmental conditions, portfolio performance Copyright © 2000 by Harcourt, Inc. All rights reserved.

The Portfolio Management Process 1. Policy statement specifies investment goals and acceptable risk levels should be reviewed periodically guides all investment decisions Copyright © 2000 by Harcourt, Inc. All rights reserved.

The Portfolio Management Process 2. Study current financial and economic conditions and forecast future trends determine strategies to meet goals requires monitoring and updates Copyright © 2000 by Harcourt, Inc. All rights reserved.

The Portfolio Management Process 3. Construct the portfolio allocate available funds to meet goals and minimize investor’s risks Copyright © 2000 by Harcourt, Inc. All rights reserved.

The Portfolio Management Process 4. Monitor and update revise policy statement as needed modify investment strategy accordingly evaluate portfolio performance Copyright © 2000 by Harcourt, Inc. All rights reserved.

The Need For A Policy Statement Understand and articulate realistic investor goals needs, objectives, and constraints financial markets and risks of investing Copyright © 2000 by Harcourt, Inc. All rights reserved.

Constructing A Policy Statement What are the real risks of an adverse financial outcome, especially in the short run? What probable emotional reactions will I have to an adverse financial outcome? How knowledgeable am I about investments and markets? Copyright © 2000 by Harcourt, Inc. All rights reserved.

Constructing A Policy Statement What other capital or income sources do I have? How important is this particular portfolio to my overall financial position? What, if any, legal restrictions may affect my investment needs? What, if any, unanticipated consequences of interim fluctuations in portfolio value might affect my investment policy? Copyright © 2000 by Harcourt, Inc. All rights reserved.

Standards For Evaluating Portfolio Performance Benchmark portfolio risk and return Matches risk preferences and investment needs analysis of risk tolerance return objective goals Copyright © 2000 by Harcourt, Inc. All rights reserved.

Realistic Investor Goals Capital preservation minimize risk of real loss strongly risk-averse or funds needed soon Capital appreciation capital gains to provide real growth over time for future need aggressive strategy with accepted risk Current income generate spendable funds Copyright © 2000 by Harcourt, Inc. All rights reserved.

Realistic Investor Goals Total return capital gains and income reinvestment moderate risk exposure Copyright © 2000 by Harcourt, Inc. All rights reserved.

Investment Constraints Liquidity needs near-term goals Time horizon longer time horizon favors risk acceptability short time horizon favors less risky investments because losses are harder to overcome in a short time frame Copyright © 2000 by Harcourt, Inc. All rights reserved.

Investment Constraints Tax concerns interest and dividends taxed at investor’s marginal tax rate capital gains may be unrealized basis and gain or loss realized revisions to capital gains tax rates tradeoff with diversification needs for employer’s stock holdings Copyright © 2000 by Harcourt, Inc. All rights reserved.

Legal and Regulatory Factors Limitations or penalties on withdrawals Fiduciary responsibilities - “prudent man” rule Investment laws prohibit insider trading Copyright © 2000 by Harcourt, Inc. All rights reserved.

Unique Needs and Preferences Personal preferences - socially conscious investments Time constraints or expertise for managing the portfolio may require professional management Large investment in employer may require consideration of diversification needs and realistic liquidity Institutional investors needs Copyright © 2000 by Harcourt, Inc. All rights reserved.

Constructing the Policy Statement Objectives - risk and return Constraints - liquidity, time horizon, tax factors, legal and regulatory constraints, and unique needs and preferences Developing a plan depends on understanding the relationship between risk and return and the importance of diversification Copyright © 2000 by Harcourt, Inc. All rights reserved.