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Bodie’Kane’Marcus: VI. Active Investment 17. Investors and the © The McGraw’Hill
Essentials of Investments, Management Investment Process Companies, 2003
Fifth Edition




Related Websites http://www.vanguard.com/educ/inveduc.html
Vanguard™s website provides information on retirement
http://www.aimr.com
planning and portfolio allocation.
This site contains information on the Chartered
http://www.investoreducation.org
Financial Analyst program.
This is the Alliance for Investor Education website. It
http://www.cfp-board.org
offers numerous sources related to financial planning
Visit this site to find information on the Certified
and education.
Financial Planner program that is oriented toward
http://www.investorhome.com
personal investors.
This site provides links to an extremely large number of
http://www.efficientfrontier.com/aa/index.shtml
other websites.
Information on models for individual asset allocation
can be found at this site.
http://www.fee-only-advisor.com/book/index.html
This site gives access to an online book that addresses
issues related to individual investing.




ranslating the aspirations and circumstances of diverse households into

T appropriate investment decisions is a daunting task. The task is equally difficult
for institutions, most of which have many stakeholders and often are regulated
by various authorities. The investment process is not easily reduced to a simple or me-
chanical algorithm.
While many principles of investments are quite general and apply to virtually all
investors, some issues are peculiar to the specific investor. For example, tax bracket,
age, risk tolerance, wealth, job prospects, and uncertainties make each investor™s cir-
cumstances somewhat unique. In this chapter we focus on the process by which in-
vestors systematically review their particular objectives, constraints, and
circumstances. Along the way, we survey some of the major classes of institutional in-
vestors and examine the special issues they must confront.
There is of course no unique “correct” investment process. However, some ap-
proaches are better than others, and it can be helpful to take one high-quality ap-
proach as a useful case study. For this reason, we will examine the systematic
approach suggested by the Association for Investment Management and Research
(AIMR). Among other things, the AIMR administers examinations to certify invest-
ment professionals as Chartered Financial Analysts. Therefore, the approach we out-
line is also one that a highly respected professional group endorses through the
curriculum that it requires investment practitioners to master. The nearby box de-
scribes how to become a Chartered Financial Analyst.
The basic framework involves dividing the investment process into four stages:
specifying objectives, specifying constraints, formulating policy, and monitoring and
updating the portfolio as needed. We will treat each of these activities in turn. We
start with a description of the major types of investors, both individual and institu-
tional, as well as their special objectives. We turn next to the constraints or cir-
cumstances peculiar to each investor class, and we consider some of the
investment policies that each can choose.
Bodie’Kane’Marcus: VI. Active Investment 17. Investors and the © The McGraw’Hill
Essentials of Investments, Management Investment Process Companies, 2003
Fifth Edition




How to Become a Chartered Financial Analyst
• Financial statement analysis and corporate finance.
The Association for Investment Management and Re-
search (AIMR) is a nonprofit international organization • Industry and company analysis.
with a mission of serving investors by educating and ex-
• Microeconomic and macroeconomic theory.
amining investment professionals. The AIMR also has
established a Code of Ethics and Standards of Profes- • Quantitative methods.
sional Conduct that establishes guidelines of practice • Principles of portfolio construction and
for investment professionals. management.
The AIMR was established in January 1990 through • Capital market theory.
the combination of the previously existing Financial An-
• Financial markets and instruments.
alysts Federation and the Institute of Chartered Finan-
• The ICFA Code of Ethics and Standards of
cial Analysts. The AIMR, through the ICFA, administers
Professional Conduct.
the program through which an investment professional
can be designated as a Chartered Financial Analyst
Beyond these exams, the candidate must have three
(CFA). This designation has become a progressively
years of work experience in money management and
more important requirement for a career in institutional
must be a member of a local Society of the Financial
money management. About 50,000 investment pro-
Analysts Federation.
fessionals are now members of the AIMR; in 2001
For more information, you can contact the Associa-
alone, more than 86,000 candidates sat for the CFA
tion of Investment Management and Research at P .O.
examination.
Box 3668, Charlottesville, VA 22903, or visit the AIMR
To become a CFA, you must pass a series of three
website at http://www.aimr.org.
annual examinations that demonstrate knowledge of:
• Valuation principles for fixed-income, equity, and
derivative securities.




17.1 INVESTORS AND OBJECTIVES
Most investors would agree with the notion that they want to earn as much money on their in-
vestments as possible. But while the concept “earn money” is simple enough after the fact,
since you simply count the profits on your investments, it is vague when applied to an invest-
ment before the fact, since you rarely will know for sure what your earnings will be. Almost
all investments entail uncertainty. Thus, while investors all wish to earn the highest rate of re-
turn possible, they also seek to avoid risk. It is not surprising that ultimately, then, investments
that offer higher expected returns will impose greater risk. This is the risk-return trade-off.
Investors will differ in their choice of investments because they differ in their willingness
to trade off expected return against risk. We describe the willingness to accept higher risk to
attain higher expected returns the investor™s risk tolerance; equivalently, we can describe at-
risk tolerance
titudes toward risk using the concept of the investor™s risk aversion, or reluctance to accept
The investor™s
risk. The nearby box explores these concepts and shows that while they seem straightforward,
willingness to accept
real-life behavior can be difficult to characterize so neatly.
higher risk to attain
higher expected These terms describe behavior: If we could observe an investor making many choices
returns. among assets whose return and risk were well understood, we could measure an investor™s risk
aversion (or risk tolerance) by observing his or her willingness to invest in various portfolios
risk aversion with differing risk and return attributes. With no access to such data, and without perfect in-
sight into the risk-return characteristics of investments, we can only surmise an investor™s risk
The investor™s
reluctance to aversion. Note that, explicitly or implicitly, many professional investors do exactly that (al-
accept risk. though, obviously they do more than just that); by choosing investments on behalf of their
clients, they make the risk-return choice for their clients.
600
Bodie’Kane’Marcus: VI. Active Investment 17. Investors and the © The McGraw’Hill
Essentials of Investments, Management Investment Process Companies, 2003
Fifth Edition




601
17 Investors and the Investment Process


Under 25 35“54 55 and Over
TA B L E 17.1
No risk 54% 55% 71%
Amount of risk
A little risk 30 28 21
investors said
they were Some risk 14 16 8
willing to A lot of risk 2 1 1
take by age
Source: From Market Facts, Inc., Chicago, IL. Reprinted by permission of Market Facts, Inc.


A natural place to begin a study of the investment process, therefore, is to specify the in-
vestor™s objectives with two indicators: return requirement and risk tolerance. The investor
then must reconcile these objectives with what is feasible, since any investor faces several
constraints. This means that the objective cannot be set as a hard number, but rather as a set of
guidelines as to the choice of assets.
Investor objectives arise from a number of factors. Understanding these factors helps in-
vestors determine appropriate objectives. It also makes it easier for professional investors to
derive appropriate policies for their clients.


Individual Investors
The basic factors affecting an individual investor usually arise from that investor™s stage in the
life cycle. The first significant investment decision for most individuals concerns education,
which is an investment in “human capital.” The major asset most people have during their
early working years is the earning power derived from their skills. For these people, the
financial risk due to illness or injury is far greater than that associated with the rate of return
on their portfolios of financial assets. At this point in the life cycle, the most important finan-
cial decisions concern insurance against the possibility of disability or death.
The first major economic asset many people acquire is their own house. One can view the
purchase of a house as a hedge1 against two types of risk. The first is the risk of increases in
rental rates. If you “pay rent to yourself,” you do not need to be concerned with increases in
the cost of housing. The second kind of risk is that the particular house or apartment where
you live may not always be available to you. By buying, you guarantee its availability.
As one ages and accumulates savings to provide for consumption during retirement, the
composition of wealth shifts from human capital toward financial capital. At this point, port-
folio choices become progressively more important. In middle age, most investors will be
willing to take on a meaningful amount of portfolio risk in order to increase their expected
rates of return. As retirement draws near, however, risk tolerance seems to diminish.
The evidence in Table 17.1 supports the life-cycle view of investment behavior. Question-
naire results suggest that attitudes shift away from risk tolerance and toward risk aversion as
investors near retirement age. With age, individuals lose the potential to recover from a disas-
trous investment performance. When they are young, investors can respond to a loss by work-
ing harder and saving more of their income. But as retirement approaches, investors realize
there will be less time to recover, hence, the shift to safe assets.

1
To hedge means to mitigate a financial risk, a possible loss from a decline in the value of an asset. The return on a
hedging asset will be higher when losses from the risk in question are greater. In other words, the return on the hedge
asset offsets the risk in question”its returns are inversely related to the exposure from that risk. The greater the neg-
ative correlation between the returns on the hedge asset and the risk, the better the hedge. For example, an insurance
policy against a specified risk is a perfect hedge, since it is designed precisely to cover a potential loss; its correlation
is perfectly negative, 1.
Bodie’Kane’Marcus: VI. Active Investment 17. Investors and the © The McGraw’Hill
Essentials of Investments, Management Investment Process Companies, 2003
Fifth Edition




Time for Investing™s Four-Letter Word
risk tolerance. The second step, many experts agree, is
What four-letter word should pop into mind when the
to ask yourself some difficult questions, such as: How
stock market takes a harrowing nose dive?
much can you stand to lose over the long term?
No, not those. R-I-S-K.
“Most people can stand to lose a heck of a lot tem-
Risk is the potential for realizing low returns or even
porarily,” says Mr. Schatsky. The real acid test, he says,
losing money, possibly preventing you from meeting im-
is how much of your portfolio™s value you can stand to
portant objectives, like sending your kids to the college
lose over months or years.
of their choice or having the retirement lifestyle you
As it turns out, most people rank as middle-of-the-
crave.
road risk-takers, say several advisers. “Only about 10%
Assessing your risk tolerance, however, can be tricky.
You must consider not only how much risk you can af- to 15% of my clients are aggressive,” says Mr. Roge.
ford to take but also how much risk you can stand to
What™s Your Risk Tolerance?
take. Determining how much risk you can stand”your
temperamental tolerance for risk”is more difficult. It Circle the letter that corresponds to your answer.
isn™t quantifiable.
1. Just 60 days after you put money into an
To that end, many financial advisers, brokerage
investment, its price falls 20 percent. Assuming
firms, and mutual-fund companies have created risk
none of the fundamentals have changed, what
quizzes to help people determine whether they are con-
would you do?
servative, moderate or aggressive investors. Some firms
a. Sell to avoid further worry and try
that offer such quizzes include Merrill Lynch, T. Rowe
something else
Price Associates Inc., Baltimore, Zurich Group Inc.™s
b. Do nothing and wait for the investment to
Scudder Kemper Investments Inc., New York, and Van-
come back
guard Group in Malvern, Pa.
c. Buy more. It was a good investment before;
Typically, risk questionnaires include 7 to 10 ques-
now it™s a cheap investment, too.
tions about a person™s investing experience, financial
2. Now look at the previous question another way.
security and tendency to make risky or conservative
Your investment fell 20 percent, but it™s part of a
choices.
portfolio being used to meet investment goals
The benefit of the questionnaires is that they are an
with three different time horizons.
objective resource people can use to get at least a
rough idea of their risk tolerance. “It™s impossible for 2A. What would you do if the goal were five years
someone to assess their risk tolerance alone,” says Mr. away?
a. Sell
Bernstein. “I may say I don™t like risk, yet will take more
b. Do nothing
risk than the average person.”

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