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c. Buy more
Many experts warn, however, that the question-
naires should be used simply as a first step to assessing




The task of life-cycle financial planning is a formidable one for most people. It is not sur-
prising that a whole industry has sprung up to provide personal financial advice.


Professional Investors
Professional investors provide investment management services for a fee. Some are employed
directly by wealthy individual investors. Most professional investors, however, either pool
many individual investor funds and manage them or serve institutional investors.

Personal trusts A personal trust is established when an individual confers legal title
personal trust
to property to another person or institution, who then manages that property for one or more
An interest in an asset
beneficiaries. The holder of the title is called the trustee. The trustee is usually a bank, a
held by a trustee
lawyer, or an investment professional. Investment of a trust is subject to state trust laws and
for the benefit of
another person. prudent investor rules that limit the types of allowable trust investment.
602
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Essentials of Investments, Management Investment Process Companies, 2003
Fifth Edition




6. A good investment opportunity just came along.
2B. What would you do if the goal were 15 years
But you have to borrow money to get in. Would
away?
a. Sell you take out a loan?
a. Definitely not
b. Do nothing
b. Perhaps
c. Buy more
c. Yes
2C. What would you do if the goal were 30 years
7. Your company is selling stock to its employees. In
away?
a. Sell three years, management plans to take the
b. Do nothing company public. Until then, you won™t be able to
c. Buy more sell your shares and you will get no dividends. But
your investment could multiply as much as 10
3. The price of your retirement investment jumps
times when the company goes public. How much
25% a month after you buy it. Again, the
money would you invest?
fundamentals haven™t changed. After you finish
a. None
gloating, what do you do?
b. Two months™ salary
a. Sell it and lock in your gains
c. Four months™ salary
b. Stay put and hope for more gain
c. Buy more: It could go higher Scoring Your Risk Tolerance
4. You™re investing for retirement, which is 15 years To score the quiz, add up the number of answers you
gave in each category a“c, then multiply as shown to
away. Which would you rather do?
a. Invest in a money-market fund or guaranteed find your score:
investment contract, giving up the possibility of
(a) answers ____ 1 ____ points
major gains, but virtually assuring the safety of
(b) answers ____ 2 ____ points
your principal
(c) answers ____ 3 ____ points
b. Invest in a 50-50 mix of bond funds and stock
funds, in hopes of getting some growth, but YOUR SCORE ____ points
also giving yourself some protection in the
If you scored. . . You may be a:
form of steady income
9“14 points Conservative investor
c. Invest in aggressive growth mutual funds
15“21 points Moderate investor
whose value will probably fluctuate
22“27 points Aggressive investor
significantly during the year, but have the
potential for impressive gains over five or
10 years
5. You just won a big prize! But which one? It™s up
to you.
a. $2,000 in cash SOURCE: Reprinted with permission from Dow Jones & Company,
b. A 50% chance to win $5,000 Inc. via Copyright Clearance Center, Inc. © 1998 Dow Jones &
c. A 20% chance to win $15,000 Company. All Rights Reserved Worldwide.




The objectives of personal trusts normally are more limited in scope than those of the indi-
vidual investor. Because of their fiduciary responsibility, personal trust managers typically are
expected to invest with more risk aversion than individual investors. Certain asset classes,
such as options and futures contracts for example, and strategies, such as short-selling (betting
the price of a security will fall) or buying on margin (borrowing up to 50% of the purchase
price), are ruled out. Short sales and margin purchases were discussed in Chapter 3.

Mutual funds Mutual funds are firms that manage pools of individual investor money. mutual fund
They invest in accordance with their objectives and issue shares that entitle investors to a pro A firm pooling and
rata portion of the income generated by the funds. managing funds
A mutual fund™s objectives are spelled out in its prospectus. We discussed mutual funds in of investors.
detail in Chapter 4.
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Essentials of Investments, Management Investment Process Companies, 2003
Fifth Edition




604 Part SIX Active Investment Management


Pension Funds There are two basic types of pension plans: defined contribution and
defined benefit. Defined contribution plans are in effect savings accounts established by the
firm for its employees. The employer contributes funds to the plan, but the employee bears all
the risk of the fund™s investment performance. These plans are called defined contribution
because the firm™s only obligation is to make the stipulated contributions to the employee™s
retirement account. The employee is responsible for directing the management of the assets,
usually by selecting among several investment funds in which the assets can be placed. In-
vestment earnings in these retirement plans are not taxed until the funds are withdrawn, usu-
ally after retirement.
In defined benefit plans, by contrast, the employer has an obligation to provide a specified
annual retirement benefit. That benefit is defined by a formula that typically takes into account
years of service and the level of salary or wages. For example, the employer may pay the re-
tired employee a yearly amount equal to 2% of the employee™s final annual salary for each
year of service. A 30-year employee would then receive an annual benefit equal to 60% of his
or her final salary. The payments are an obligation of the employer, and the assets in the pen-
sion fund provide collateral for the promised benefits. If the investment performance of the as-
sets is poor, the firm is obligated to make up the shortfall by contributing additional assets to
the fund. In contrast to defined contribution plans, the risk surrounding investment perfor-
mance in defined benefit plans is borne by the firm.
A pension actuary makes an assumption about the rate of return that will be earned on the
plan™s assets and uses this assumed rate to compute the amount the firm must contribute reg-
ularly to fund the plan™s liabilities. For example, if the actuary assumes a rate of return of 10%,
then the firm must contribute $385.54 now to fund $1,000 of pension liabilities that will arise
in 10 years, because $385.54 1.1010 $1,000.
If a pension fund™s actual rate of return exceeds the actuarial assumed rate, then the firm™s
shareholders reap an unanticipated gain, because the excess return can be used to reduce fu-
ture contributions. If the plan™s actual rate of return falls short of the assumed rate, however,
the firm will have to increase future contributions. Because the sponsoring firm™s sharehold-
ers bear the risk in a defined benefit pension plan, the objective of the plan will be consistent
with the objective of the firm™s shareholders.
Many pension plans view their assumed actuarial rate of return as their target rate of return
and have little tolerance for earning less than that. Hence, they will take only as much risk as
necessary to earn the actuarial rate.


Life Insurance Companies
Life insurance companies generally invest so as to hedge their liabilities, which are defined by
the policies they write. The company can reduce its risk by investing in assets that will return
more in the event the insurance policy coverage becomes more expensive.
For example, if the company writes a policy that pays a death benefit linked to the con-
sumer price index, then the company is subject to inflation risk. It might search for assets ex-
pected to return more when the rate of inflation rises, thus hedging the price-index linkage of
the policy.
There are as many objectives as there are distinct types of insurance policies. Until the
1970s, only two types of life insurance policies were available for individuals: whole-life and
term.
A whole-life insurance policy combines a death benefit with a kind of savings plan that
provides for a gradual buildup of cash value that the policyholder can withdraw later in life,
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Essentials of Investments, Management Investment Process Companies, 2003
Fifth Edition




605
17 Investors and the Investment Process


usually at age 65. Term insurance, on the other hand, provides death benefits only, with no
buildup of cash value.
The interest rate imbedded in the schedule of cash value accumulation promised under the
whole-life policy is a fixed rate. One way life insurance companies try to hedge this liability
is by investing in long-term bonds. Often the insured individual has the right to borrow at a
prespecified fixed interest rate against the cash value of the policy.
During the high-interest-rate years of the 1970s and early 1980s, many older whole-life
policies allowed policyholders to borrow at rates as low as 4 or 5% per year; some holders
borrowed heavily against the cash value to invest in assets paying double-digit yields. Other
actual and potential policyholders abandoned whole-life policies and took out term insurance,
which accounted for more than half the volume of new sales of individual life policies.
In response to these developments, the insurance industry came up with two new policy
types: variable life and universal life. A variable life policy entitles the insured to a fixed death
benefit plus a cash value that can be invested in the policyholder™s choice of mutual funds. A
universal life policy allows policyholders to increase or reduce either the insurance premium
(the annual fee paid on the policy) or the death benefit (the cash amount paid to beneficiaries
in the event of death) according to their changing needs. Furthermore, the interest rate on the
cash value component changes with market interest rates.
The great advantage of variable and universal life insurance policies is that earnings on the
cash value are not taxed until the money is withdrawn.

Non-Life-Insurance Companies
Non-life-insurance companies such as property and casualty insurers have investable funds
primarily because they pay claims after they collect policy premiums. Typically, they are con-
servative in their attitude toward risk.
A common thread in the objectives of pension plans and insurance companies is the need
to hedge predictable long-term liabilities. Investment strategies typically call for hedging these
liabilities with bonds of various maturities.


Banks
Most bank investments are loans to businesses and consumers, and most of their liabilities are
accounts of depositors. As investors, banks try to match the risk of assets to liabilities while
earning a profitable spread between the lending and borrowing rates. The difference between
the interest charged to a borrower and the interest rate that banks pay on their liabilities is
called the bank interest rate spread.
Most liabilities of banks and thrift institutions are checking accounts, time or savings de-
posits, and certificates of deposit (CDs). Checking account funds may be withdrawn at any
time, so they are of the shortest maturity. Time or savings deposits are of various maturities.
Some time deposits may extend as long as seven years, but, on average, they are of fairly short
maturity. CDs are bonds of various maturities that the bank issues to investors. While the
range of maturities is from 90 days to 10 years, the average is about one year.
Traditionally, a large part of the loan portfolio of savings and loan (S&L) institutions was
in collateralized real estate loans, better known as mortgages. Typically, mortgages are of 15
to 30 years, significantly longer than the maturity of the average liability. Thus, profits were
exposed to interest rate risk. When rates rose, thrifts had to pay higher rates to depositors,
while the income from their longer-term investments was relatively fixed. This problem prob-
ably was a contributing factor in the S&L debacle of the 1980s. When interest rates rose
Bodie’Kane’Marcus: VI. Active Investment 17. Investors and the © The McGraw’Hill
Essentials of Investments, Management Investment Process Companies, 2003
Fifth Edition




606 Part SIX Active Investment Management


throughout the 1970s, the financial condition of many banks and thrift institutions deterio-
rated, making them more willing to assume greater risk in order to achieve higher returns. The
greater risk of the loan portfolios was of little concern to depositors because deposits were in-
sured by the Federal Deposit Insurance Corporation (FDIC) or the now-defunct Federal Sav-
ings and Loan Insurance Corporation (FSLIC).
As we noted in Chapter 2, most long-term fixed-rate mortgages today are securitized into
pass-through certificates and held as securities in the portfolios of mutual funds, pension
funds, and other institutional investors. Mortgage originators typically sell the mortgages they
originate to pass-through agencies like Fannie Mae or Freddie Mac rather than holding them
in a portfolio. They earn their profits on mortgage origination and servicing fees. The trend
away from maintaining portfolio holdings of long-term mortgages also has reduced interest
rate risk.


Endowment Funds
Endowment funds are held by organizations chartered to use their money for specific non-
endowment funds
profit purposes. They are financed by gifts from one or more sponsors and are typically man-
Portfolios operated
aged by educational, cultural, and charitable organizations or by independent foundations
for the benefit of a
established solely to carry out the fund™s specific purposes. Generally, the investment objec-
nonprofit entity.
tives of an endowment fund are to produce a steady flow of income subject to only a moder-
ate degree of risk. Trustees of an endowment fund, however, can specify other objectives as
circumstances dictate.


>
1. Describe several distinguishing characteristics of endowment funds that differen-
Concept
tiate them from pension funds.
CHECK

17.2 INVESTOR CONSTRAINTS
Even with identical attitudes toward risk, different households and institutions might choose

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