1. Investment Policy Statement
Portfolio Management
Investment Policy Statement
Otto Khatamov

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

3. Portfolio Management: Overview
Client needs: Investment policy statement
Focus: Investor’s short-term and long-term needs, expectations
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
Portfolio manager: Implement the plan by constructing the portfolio
Focus: Meet the investor’s needs at minimum risk levels
Client/Portfolio manager: Feedback loop
Monitor and update investor needs, environmental conditions, evaluate portfolio performance

4. Investment Policy Statement
The preliminaries
Basic needs
Investment and life cycle net worth
Two important components of the investment policy statement
Investment objectives
Individuals versus institutions
Investment constraints
Investment Policy Statement: In detail

5. Investment Policy Statement
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

6. Investment Policy Statement
The preliminaries
Rise and fall of personal Net worth over the lifetime
Accumulation phase
Long-term: retirement, childern’s needs
Short-term:
House, car
Consolidation phase
Long-term: retirement
Short-term: vacations, childern’s needs
Spending phase
Long-term: estate planning
Short-term: lifestyle needs gifts

7. Investment Policy Statement
The preliminaries
Benefits from investing early

8. Investment Policy Statement
The preliminaries
Rise and fall of personal Net worth over the lifetime
Accumulation phase
Long-term: retirement, childern’s needs
Short-term:
House, car
Consolidation phase
Long-term: retirement
Short-term: vacations, childern’s needs
Spending phase
Long-term: estate planning
Short-term: lifestyle needs gifts

9. Investment Policy Statement
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:
Investor’s willingness to accept risk
Investor’s ability to accept risk

10. Investment Policy Statement
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 Years
6-10 Years
11+ Years
High
20% cash
40% bonds
40% stocks
10% cash
30% bonds
60% stocks
100% stocks
Moderate
30% cash
50% bonds
20% bonds
80% stocks
Low
100% cash
20% stocks

11. Investment Policy Statement
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.
Series
Geometric Average
Arithmetic average
Standard 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 Bills
3.78%
3.82%
3.18%

12. Investment Policy Statement
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.

13. Investment Policy Statement
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)

14. Investment Policy Statement
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.

15. Investment Policy Statement
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.

16. Investment Policy Statement
Inputs to the investment policy statement
Investment objectives: Individuals versus institutions
Type of Investor
Return requirements
Risk Tolerance
Individual
Depends on stage of life, circumstances and obligations
Variable
Mutual funds
Pension funds
Assumed actuarial rate
Depends on proximity of payouts
Endowment funds
Return to cover annual spending, investment expenses, and expected inflation
Generally conservative
Life insurance companies
Return to meet expenses and profit objectives
Conservative due to regulations
Non-life insurance
Financial needs and competition
Conservative due to regulation
Banks
Cost of capital

17. Investment Policy Statement
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

18. Investment Policy Statement
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

19. Investment Policy Statement
Inputs to the investment policy statement
Investment constraints
Tax concerns
Taxable income from interest, dividends or rents are taxable at the investor’s 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

20. Investment Policy Statement
Inputs to the investment policy statement
Investment constraints
Legal and regulatory factors
Fund withdrawal from a 401(k) plan before the age of are taxable to an additional 10% penalty
25-year old vs 65-year old investor
Similar concerns for both investors

21. Investment Policy Statement
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

22. Investment Policy Statement
Inputs to the investment policy statement
Investment constraints: Individuals versus institutions
Type of Investor
Liquidity
Horizon
Regulations
Taxes
Individual
Variable
Life cycle
Few
Mutual funds
High
None
Pension funds
Young, low; mature, high
Long
Yes
Endowment funds
Low
Life insurance companies
Non-life insurance
Short
Banks
Changing

23. Investment Policy Statement
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

24. 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

25. Readings Maginn, Tuttle, Pinto and McLeavey, Chapters 1 and 2
Reilly and Brown, Chapter 2
Bodie, Kane and Marcus, Chapter 26