Outline
Introduction x Why setting objectives can be difficult x Portfolio objectives x The importance of primary and secondary objectives x Other factors to consider in establishing objectives x Portfolio dedication
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Introduction
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Setting objectives is important for every person and institution that uses financial planning
Too many investors have a casual attitude It is easy to be imprecise in communicating with the portfolio manager Gallup survey finds 39% believe stocks will return 15% annually for next ten year
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Introduction (contd)
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Semantics Indecision Subjectivity Multiple beneficiaries Investment policy versus investment strategy
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Semantics
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Growth, income, return on investment, and risk mean different things to different people
E.g., a savings account provides income only; it has no growth potential There must be a clear understanding of the terms when entrusting money to a fund manager
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Semantics (contd)
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Indecision
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The clients inability to make a decision E.g., a bank customer wants to have interest compounded but have the interest send home each month
Subjectivity
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Multiple Beneficiaries
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Investment policy deals with decisions that have been made about long-term investment activities, eligible investment categories, and the allocation of funds among the categories
E.g., a pension fund decides never to place more than 30% in common stock
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Investment strategy deals with short-term activities that are consistent with established policy and that will contribute positively toward obtaining the objective of the portfolio
E.g., a managers may be required to maintain at least 30% equity by policy but decides to put 50% in the stock market because of a belief that the market will advance in the near future
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Portfolio Objectives
x x x x
Preconditions Traditional portfolio objectives Tax-free income generation Portfolio objectives and expected utility
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Preconditions
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Stability of Principal
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Income
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Income (contd)
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Growth of Income
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Often seek to have the annual income increase by at least the rate of inflation Requires some investment in equity securities
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Capital Appreciation
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The goal is for the portfolio to grow in value and not to generate income Appropriate for investors who have no income needs
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The investor can defer taxes for many years by successful long-term growth stock investing
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29.28 20 = 4 (1 + R) R = 10.00%
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26.68 20 = (1 + R) 4 R = 7.47%
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23.61 + R) (1
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22.91 + R) (1
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Invest directly in municipal bonds for an income strategy Invest in a mix of municipal bonds and common stock for a growth-of-income strategy
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Invest in a municipal bond mutual fund for a stability of principal strategy Tax-free income generation is unrealistic for a capital appreciation strategy
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Introduction
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The secondary objective indicates what is next in importance after specification of the primary objective
E.g., an investor chose income as the primary objective, but:
Does not want to take a lot of risk with the invested money (stability of principal) Wants to keep up with inflation (growth of income)
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Short-term debt
Inconsistent objectives Infrequent objectives Portfolio splitting Liquidity The role of cash
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Inconsistent Objectives
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Infrequent Objectives
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Portfolio Splitting
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A fund manager receives instructions that require that the portfolio be managed in more than one part
E.g., endowment funds
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Components will have different objectives A more convenient way of administering the fund than trying to establish a single, overall objective
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Liquidity
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Liquidity is a measure of the ease with which something can be converted to cash Clients may desire some liquidity
Options: invest a portion of the portfolio in money market mutual funds or cash management accounts at brokerage firms with check-writing privileges
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Cash contributes to portfolio stability, especially during periods of rising interest rates Cash includes:
Currency Money market instruments
E.g., Treasury bills
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Portfolio Dedication
x x x
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Introduction
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Portfolio dedication (liability funding) involves managing an asset portfolio so that it services the requirements of a corresponding liability or portfolio of liabilities
Overlays the primary and secondary investment objectives The two principal methods are cash matching and duration matching
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Cash Matching
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The most common form of portfolio dedication A manager assembles a portfolio of bonds whose cash flows match as nearly as possible the requirements of a particular liability
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Duration Matching
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Involves constructing a portfolio of assets that pays the billsassociated with a liability or stream of liabilities Duration is a measure of interest rate risk
The higher the duration, the greater the fluctuation in the price of a bond due to interest rate changes
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In a duration-matched portfolio:
A rise in interest rates results in a decline in the portfolios value that is approximately offset by additional income earned from the higher reinvestment rate A fall in interest rates results in a decline in income from reinvested funds that is approximately offset by the increase in the market value of the portfolio
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