Contemporary Investments: Chapter 20 Chapter 20 BUILDING AND MANAGING AN INVESTMENTPORTFOLIO What is the process of building and managing an investment portfolio? How is an investment policy developed? How do capital market assumptions affect the investment process? What is asset allocation? What does monitoring a portfolio involve?

Contemporary Investments: Chapter 20 Constructing and managing an investment portfolio Investment policy –Investment objectives –Investment constraints –Preferences Formulating financial market expectations

Contemporary Investments: Chapter 20 Constructing and managing an investment portfolio- Cont. Portfolio construction –Strategic asset allocation –Tactical asset allocation Portfolio monitoring

Contemporary Investments: Chapter 20 Figure 20.1 – An Outline of Portfolio Construction and Management Process

Contemporary Investments: Chapter 20 Developing an investment policy Differences between individuals and institutions –Time horizon –Changes in investor characteristics –Risk and behavior –Reasons for investing –Regulatory and legal constraints –Taxes

Contemporary Investments: Chapter 20 Formulating investment objectives The three objectives –Growth in capital –Preservation of capital –Current income Prioritizing these objectives Real life examples –Mark’s retirement –Kim’s daughter’s college education

Contemporary Investments: Chapter 20 Constraints Definition Time horizon Liquidity needs

Contemporary Investments: Chapter 20 Constraints –Cont. Taxes –Capital gains are taxed at a lower rate than ordinary income –Only realized capital gains are taxed –Retirement plans offer substantial tax benefits –Estate tax rates are higher than income tax rates Regulatory and legal constraints Special needs, circumstances and goals

Contemporary Investments: Chapter 20 Financial market expectations Macro-expectations –Based on the historical record –Stocks have outperformed bonds and cash investments by substantial margins –Stock returns have exhibited much more year- to-year variability than other investment returns –Much of the variability in stock returns has disappeared over longer holding periods

Contemporary Investments: Chapter 20 Figure 20.2 – The Growth of a $1,000 Investment,

Contemporary Investments: Chapter 20 Some observations Stocks are better long-term investments than other financial assets Long-term returns are far more predictable (or less uncertain) than short-term returns The historical record is just that, a record of what happened

Contemporary Investments: Chapter 20 Financial market expectations - Cont. Micro-expectations –Definition –Based on the historical record –Micro-expectations are more difficult

Contemporary Investments: Chapter 20 Figure 20.3 – Returns from Large- and Small-Company Stocks

Contemporary Investments: Chapter 20 Asset allocation Types of asset allocation decisions –Strategic asset allocation Based on objectives, return requirements, time horizon and risk preferences Role of macro and micro-expectations –Tactical asset allocation –Which is more important

Contemporary Investments: Chapter 20 Asset allocation - Cont. –Life cycle approach to asset allocation –Diversification and portfolio optimization

Contemporary Investments: Chapter 20 Figure 20.4 – A Simple Model of Asset Allocation

Contemporary Investments: Chapter 20 Investment Insight – Some Suggested Retirement Portfolios

Contemporary Investments: Chapter 20 Figure 20.5 – Efficient Frontier: Combinations of Large Stocks, Small Stocks, Bonds, and Bills

Contemporary Investments: Chapter 20 Monitoring portfolios Active versus passive management Changes in investor circumstances –Getting older –Increases in wealth –Change in family status Rebalancing Performance measures and evaluation