Subject 3. Investment objectives and constraints

Objectives

  • Risk objective.

    To determine a risk objective, there are several steps:

    • Specify a risk measure (or measures) such as standard deviation.
    • Determine the investor's willingness to take risk.
    • Synthesize the investor's willingness and ability into the investor's risk tolerance. 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. Investment firms survey clients to gauge their risk tolerance.
    • Specify an objective using the measure(s) in the first step above.

  • Return objective.

    To determine a return objective, there are several steps:

    • Specify the return measure such as total nominal return.
    • Determine the investor's stated return desire.
    • Determine the investor's required rate of return.
    • Specify an objective in terms of the return measure in the first step above.

Constraints

The investor's risk and return objectives are set within the context of several constraints.

  • Liquidity.

    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.

  • Time horizon.

    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.

  • Tax concerns.

    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.

  • Legal and regulatory factors.

    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.

  • Unique needs and preferences.

    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.

Practice Question 1

An investment's return on investment usually has two components, one of which is ______ which reflects the cash you receive directly while you own the investment.

A. the capital gain.
B. the income component.
C. your reward for bearing risk.
Correct Answer: B

Practice Question 2

The two most critical elements of an investment objective are:

A. liquidity needs and time horizon.
B. risk tolerance and return objective.
C. capital appreciation and total return.
Correct Answer: B

Risk and return issues are paramount. Other factors may articulate the objective.

Practice Question 3

A total return objective is best described as:

A. similar to capital appreciation with reinvestment of current income.
B. bias toward income versus capital gains.
C. concern with preservation of capital.
Correct Answer: A

Total return includes both capital gains and income (dividend or interest) generated from a portfolio.

Practice Question 4

A long investment time horizon is typically associated with:

A. low-risk investments
B. deferral of capital gains
C. the need for current income
Correct Answer: B

A long holding period allows securities to appreciate without realization of capital gains. This also defers payment of tax liabilities.

Practice Question 5

Setting investor objectives in the investment policy statement should be preceded by:

A. analyzing the pros and cons of alternative investment strategies.
B. a careful analysis of the client's risk tolerance.
C. discussing the client's total needs.
Correct Answer: B

Setting investor objectives in the investment policy statement should be preceded by a careful analysis of the client's risk tolerance.

Practice Question 6

Risk tolerance is affected by:

I. a person's current insurance coverage and cash reserves
II. an individual's family situation.
III. one's current net worth and income expectations.
Correct Answer: I, II and III

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.

Practice Question 7

Investment constraints in an investment plan include:

I. liquidity needs.
II. an investment time horizon.
III. tax factors.
IV. legal and regulatory constraints.
V. unique needs and preferences.
Correct Answer: I, II, III, IV and V

Practice Question 8

Which of the following statements regarding individual and institutional investors is (are) INCORRECT?

I. Individuals define risk as "losing money", while institutions view risk as variance (or standard deviation) of returns.
II. Individuals are categorized according to their personalities and unique circumstances, whereas institutions are categorized by the investment characteristics of those that have a beneficial interest in the portfolios of pension funds, endowment funds, banks, insurance companies and mutual funds.
III. Individuals are defined financially by their assets and goals (particularly as they related to their life cycle), while institutions are typically concentrated within precise asset and liability parameters.
IV. Institutions have great flexibility in selecting their investments, whereas individuals are managed and regulated by ERISA (Employee Retirement Income Security Act) as well as other legal constraints.
Correct Answer: IV

Practice Question 9

A time horizon may be considered to be a(n):

A. return objective.
B. risk objective.
C. constraint.

Correct Answer: C

Shorter time horizons generally indicate lower risk tolerance and hence constrain portfolio choice, making it more conservative.

Practice Question 10

The ______ of the investor is (are) his or her investment goals, expressed in terms of both risk and return.

A. objectives
B. policy statement
C. constraints
Correct Answer: A

A careful analysis of the client's risk tolerance should precede any discussion of return objectives.

Practice Question 11

The investor's objectives that should be identified in the investment policy statement are his/her:

A. risk profile and goals.
B. investment goals expressed in terms of both risk and returns
C. current net worth and income expectations.
Correct Answer: B

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.

Practice Question 12

Investors with long investment time horizons:

A. generally require less liquidity and can tolerate greater portfolio risk.
B. generally require more liquidity and can tolerate greater portfolio risk.
C. generally require less liquidity and can tolerate less portfolio risk.
Correct Answer: A

Investors with long investment time horizons generally require less liquidity and can tolerate greater portfolio risk.

Practice Question 13

The investment objectives of an investor should be expressed in terms of

A. Risk and expected return.
B. Stock market expectations.
C. Investment horizon and liquidity concerns.
Correct Answer: A

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.

Practice Question 14

Which of the following statement(s) is (are) true with respect to constructing the proper objectives for an investor?

I. The required rate of return that an investor demands will determine how much risk the manager should take.
II. As the client's risk aversion increases, the manager may include more aggressive investments in the portfolio.
III. If the investor's objective is heavily focused towards income, then it would not be prudent to include securities that are growth oriented into the portfolio.
IV. An account that will need to generate income in step with inflation must be measured in terms of real performance.

A. II, III and IV
B. I and III
C. IV only
Correct Answer: C

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.

Practice Question 15

Which of the following statements is (are) true with respect to setting the proper constraints in managing a portfolio?

I. The more certain an investor's financial future, the less liquidity will be in the portfolio, holding everything else constant.
II. The longer the investment horizon, the more emphasis must be placed on any current expectations with regards to the relative performance of the various asset classes.
III. It would be imprudent to include many income oriented securities in a portfolio that belongs to an investor in a high tax bracket.
IV. Low levels of sophistication are an indication that an investor is inexperienced and hence the manager should overestimate the investor's level of risk tolerance.

A. I and III only.
B. III, IV only.
C. II, III, and IV only.
Correct Answer: A

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.

Practice Question 16

Which of the following items would not generally be addressed when constructing an investment policy?

A. The required rate of return expected for the risk that's being taken.
B. Credit rating above which securities may be considered, and eligible asset categories that may be included in the portfolio.
C. Allowable margins within which the manager may deviate away from the original asset mix.
Correct Answer: A

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.

Practice Question 17

Which of the following statements is (are) true with respect to the portfolio management process?

I. Individuals generally define risk in term of standard deviation.
II. The investment horizon for investors in the accumulation phase will be the longest relative to the other phases.
III. The level of return that the investor desires will determine how much risk that the investment manager should take.
IV. The investment horizon is deemed to end at the investor's age of death.

A. I, II, IV only
B. II and III only
C. II only
Correct Answer: C

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.