Chapter

Investors and the

22 Investment Process

Bodie, Kane, and Marcus

Essentials of Investments
12th Edition
 • The CFA Institute divides the process of
investment management into three main
elements that constitute a dynamic
feedback loop: planning, execution, and
feedback.

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 Figure 22.1 Investment Management Process

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 Table 22.1 Components of Investment Management Process

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 Table 22.2 Components of Investment Policy Statement

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 Table 22.3 Determination of Portfolio Policies

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 22.2 Major Investor Types

• Objectives and constraints vary widely

across investor types. In this section, we
provide a brief overview of eight major
categories of investors, focusing on their
return objectives and tolerance for risk.

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 22.2 Major Investor Types
• Individual Investors
• The basic factors affecting individual investor return
requirements and risk tolerance are life-cycle stage
and individual preferences.
• Balance risk/return throughout life
• Wealth shifts from human capital to financial capital
with age, increasing portfolio choice importance
• Life cycle critical in determining risk-return trade-off
• Younger investors are willing to bear more risk for higher
returns
• Older investors are willing to accept lower returns for lower
risk
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 22.2 Major Investor Types
• Professional Investors
• Personal trusts
• Personal trusts are established when an individual confers legal
title to property to another person or institution (the trustee) to
manage that property for one or more beneficiaries.
• Trustee holds interest in asset for benefit of another person

• The trustee is usually a bank

• Mutual funds
• Mutual funds are pools of investors’ money.

• Objectives vary with type of fund

• Detailed in prospectus.

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 22.2 Investor Objectives
• Professional Investors
• Pension funds
• Pension fund objectives depend on the type of
pension plan. There are two basic types:
• Defined benefit
• Depends on tenure, salary; investment risk borne by company
• Defined contribution
• Employee and employer contribute set amount to individual’s
retirement fund; benefit depends on investment performance;
investment risk borne by individual

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 22.2 Investor Objectives

• Professional Investors
• Endowment funds
• are organizations chartered to use their money for
specific nonprofit purposes. They are financed by gifts
from one or more sponsors and are typically managed
by educational, cultural, and charitable organizations
or by independent foundations established.

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 22.2 Investor Objectives

• Insurance Companies
• Life insurance companies
• Life insurance companies generally try to invest so as to
hedge their liabilities, which are defined by the policies
they write
• Whole-life policies (insurance + savings at fixed rate)
• Variations of the two with variable-rate savings

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 22.2 Investor Objectives

• Insurance Companies
• Non-life-insurance companies
• Premiums not paid back to policyholders for losses,
are invested
• Hedge against potential claims

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 22.2 Investor Objectives

• Banks
• Sources of funds: predominantly deposits,
some borrowed funds
• Investment of funds: predominantly loans and
fixed-income securities
• Active in securitized loan and asset markets
• Not active in equity except in trust function

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 Table 22.4 Matrix of Objectives

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 22.3 Investor Constraints
• Liquidity
• Speed and ease with which asset can be
converted into cash at or near its value
• Need for cash on short notice increases liquidity
requirement, decreases return
• Investment Horizon
• Planned liquidation date
• Affects portfolio risk and security maturity dates

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 22.3 Investor Constraints

• Regulations
• Professional and institutional investors are
constrained by many regulations.
• Institutional investors
• Example: Mutual funds may not hold more than 5% of
the stock of any publicly traded corporation
• Prudent investor rule
• The fiduciary responsibility of a professional investor

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 22.3 Investor Constraints
• Tax Considerations
• Special considerations related to tax position of
investor
• Unique Needs
• Special considerations related to underlying
investors.
• A client may have religious or ethical objections to
investing in particular stocks or sectors.
• Diversify away from industry in which they work
• Financial needs may determine riskiness of portfolio
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 Table 22.5 Matrix of Constraints

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 22.4 Investment Policies
• Consideration of their objectives and constraints
leads investors to a set of investment policies.
The policies column in Table 22.3 lists the various
dimensions of portfolio management
policymaking—asset allocation, diversification,
risk and tax positioning, and income generation.
• By far the most important part of policy
determination is asset allocation, that is, deciding
how much of the portfolio to invest in each major
asset category. We can view the process of asset
allocation as consisting of the following steps:

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 22.4 Investment Policies
1- Specify asset classes to be included in
the portfolio. The major classes usually
considered are the following:
a. Money market instruments (usually called cash).
b. Fixed-income securities (usually called bonds).
c. Stocks.
d. Real estate.
e. Precious metals.
f. Other.

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 22.4 Investment Policies
2- Specify capital market expectations.
This step consists of using both historical
data and economic analysis to determine
your expectations of future rates of return
over the relevant holding period on the
assets to be considered for inclusion in the
portfolio.

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 22.4 Investment Policies
3- Derive the efficient portfolio frontier.
This step consists of finding portfolios that
achieve the maximum expected return for
any given degree of risk.
4. Find the optimal asset mix. This step
consists of selecting the efficient portfolio
that best meets your risk and return
objectives while satisfying the constraints
you face.

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 Figure 22.2 Asset Allocation and Security Selection

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 22.4 Investment Policies: Active vs. Passive

Active Passive
Aims for better than average returns Aims for average returns
Active asset allocation Does not time the market
Active security selection Indexing
Balanced  likely better returns Seeks low cost financial products

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 22.5 Monitoring and Revising Investment Portfolios

• By time of completion, inputs may be out of date

 strategy revisions
• Client circumstances can change over time
• As prices change  Portfolio weights change
• Asset allocation will change over time
• Investing is a dynamic process: Update and
Reevaluate

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