To determine a risk objective, there are several steps:
To determine a return objective, there are several steps:
The investor's risk and return objectives are set within the context of several constraints.
Liquidity in the investment sense is the ability to quickly convert investments into cash at a price close to their market value. Investors may need some cash in excess of the contribution rate or the savings rate, but they don't want to sell assets at unfavorable terms. This requirement may stem from current income needs or from non-recurring needs and can be met by cash-equivalents or by converting other assets into cash.
This is the time between making an investment and needing the funds. Investment objectives and associated time horizons may be short-term, long-term, or a combination of these two. There is a relationship between an investor's time horizon, asset allocation, liquidity needs and the ability to handle risk. Investors with long investment horizons generally require less liquidity and can tolerate greater portfolio risk, and losses are harder to overcome during a short time frame for investors with short investment horizons.
Investment planning is complicated by the tax code. For example, income from dividends, interests and rents is taxable at the investor's marginal tax rate. Capital gains are only taxable after the asset has been sold for a price higher than its cost or basis, but unrealized capital gains are not taxable at all (the tax liability can be deferred indefinitely). Sometimes we have to make a trade-off between taxes and diversification needs. Other factors, such as tax deductible IRA contributions and 401(k) plans also complicate this issue.
Individual investors are generally not affected by regulations, but professional and institutional investors need to be aware of regulations. For example, a government agency may limit the uses of certain asset classes in retirement portfolios.
There may be a number of unusual considerations that affects the investor's risk-return profile. For example, investment requirements may depend on goal spending. Thus, individuals will require adequate funds to be set aside to meet known spending demands. Moreover, many investors may want to exclude certain investments from the portfolio based on personal preferences. For example, investors may specify that no investments in their portfolio be affiliated with the manufacture or distribution of alcohol, pornography, tobacco or environmental harmful products.
A. the capital gain.
A. liquidity needs and time horizon.
Risk and return issues are paramount. Other factors may articulate the objective.
A. similar to capital appreciation with reinvestment of current income.
Total return includes both capital gains and income (dividend or interest) generated from a portfolio.
A. low-risk investments
A long holding period allows securities to appreciate without realization of capital gains. This also defers payment of tax liabilities.
A. analyzing the pros and cons of alternative investment strategies.
Setting investor objectives in the investment policy statement should be preceded by a careful analysis of the client's risk tolerance.
I. a person's current insurance coverage and cash reserves
Risk tolerance is affected by an individual's psychological makeup, current insurance coverage, cash reserves, family situation, age, current net worth and income expectations, etc.
I. liquidity needs.
I. Individuals define risk as "losing money", while institutions view risk as variance (or standard deviation) of returns.
A. return objective.
Shorter time horizons generally indicate lower risk tolerance and hence constrain portfolio choice, making it more conservative.
A careful analysis of the client's risk tolerance should precede any discussion of return objectives.
A. risk profile and goals.
The investor's objectives that should be identified in the investment policy statement are his/her investment goals expressed in terms of both risk and returns.
A. generally require less liquidity and can tolerate greater portfolio risk.
Investors with long investment time horizons generally require less liquidity and can tolerate greater portfolio risk.
A. Risk and expected return.
In an efficient market, a stock's expected return has built in all the risk factors. Therefore, an investor's task is simply to determine how much risk he or she is willing to take, and the markets will determine what the equilibrium rate of return should be at that given level of risk.
I. The required rate of return that an investor demands will determine how much risk the manager should take.
A. II, III and IV
I is false because the amount of risk an investor is willing to take will establish what kinds of return can be realistically expected to be earned from the portfolio.
II is incorrect because as the client's risk aversion increases, the manager must include more conservative investments in the portfolio. Candidates must be careful not to confuse risk aversion with risk tolerance, as these two terms have opposite meanings.
As intuitive as III sounds, it may be very prudent to include growth securities in a portfolio that requires income. The reason - it is total return that matters, and not specifically its two components of income and growth.
I. The more certain an investor's financial future, the less liquidity will be in the portfolio, holding everything else constant.
A. I and III only.
II is incorrect because the longer the investment horizon, the less emphasis must be placed on any current expectations with regards to the relative performance of the various asset classes. Instead, the manager can focus on choosing asset mix based on their long term expected performance.
IV is incorrect because low levels of sophistication that an investor is inexperienced and hence the manager should overestimate the investor's level of risk "aversion", which is the same thing as underestimating the investor's level of risk tolerance.
A. The required rate of return expected for the risk that's being taken.
While the investment policy will discuss the type or returns that are expected (i.e., Growth, income, or income and growth), it is not often that a specific expected return is incorporated into the policy statement.
I. Individuals generally define risk in term of standard deviation.
A. I, II, IV only
I is incorrect because individuals generally define risk in more subjective terms, for instance, prices below which they would incur a paper loss.
III is incorrect because it's the other way around, the level of risk that the investor can handle will determine what return to respect from the portfolio.
IV is incorrect because the portfolio could still be managed on behalf of beneficiaries even after the client's death. Thus the investment horizon approaches its end at the time when the portfolio is expected to be either fully or partially liquidated.