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different investment portfolios because of their differing circumstances. These circumstances
include tax status, requirements for liquidity or a flow of income from the portfolio, or vari-
ous regulatory restrictions. These circumstances impose constraints on investor choice. To-
gether, objectives and constraints determine appropriate investment policy.
As noted, constraints usually have to do with investor circumstances. For example, if a
family has children about to enter college, there will be a high demand for liquidity since cash
will be needed to pay tuition bills. Other times, however, constraints are imposed externally.
For example, banks and trusts are subject to legal limitations on the types of assets they may
hold in their portfolios. Finally, some constraints are self-imposed. For example, “social in-
vesting” means that investors will not hold shares of firms involved in ethically objectionable
activities. Some criteria that have been used to judge firms as ineligible for a portfolio are:
involvement in nuclear power generation; production of tobacco or alcohol; participation in
polluting activities.
Five common types of constraints are described below.

liquidity Liquidity
Liquidity refers to the
Liquidity is the speed and ease with which an asset can be sold and still fetch a fair price. It
speed and ease with
is a relationship between the time dimension (how long it will take to sell) and the price
which an asset can
dimension (the discount from fair market price) of an investment asset.
be converted to cash.
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17 Investors and the Investment Process

When an actual concrete measure of liquidity is necessary, one thinks of the discount when
an immediate sale is unavoidable.2 Cash and money market instruments such as Treasury bills
and commercial paper, where the bid“ask spread is a fraction of 1%, are the most liquid assets,
and real estate is among the least liquid. Office buildings and manufacturing structures in ex-
treme cases can suffer a 50% liquidity discount.
Both individual and institutional investors must consider how likely they are to require
cash at short notice. From this likelihood, they establish the minimum level of liquid assets
they need in the investment portfolio.

Investment Horizon
This is the planned liquidation date of the investment. Examples of an individual™s
investment horizon could be the time to fund a college education or the retirement date for a investment
wage earner. For a university or hospital endowment, an investment horizon could relate to the horizon
time to fund a major construction project. Horizon dates must be considered when investors The planned
choose between assets of various maturities. For example, the maturity date of a bond might liquidation date.
make it a more attractive investment if it coincides with a date on which cash is needed.

Only professional and institutional investors are constrained by regulations. First and foremost
is the prudent investor rule. That is, professional investors who manage other people™s prudent
money have a fiduciary responsibility to restrict investment to assets that would have been ap- investor rule
proved by a prudent investor. The law is purposefully nonspecific. Every professional investor The fiduciary
must stand ready to defend an investment policy in a court of law, and interpretation may dif- responsibility of a
fer according to the standards of the times. professional investor.
Also, specific regulations apply to various institutional investors. For instance, U.S. mutual
funds may not hold more than 5% of the shares of any publicly traded corporation.
Sometimes, “self-imposed” regulations also affect the investment choice. We have noted
several times, for example, that mutual funds describe their investment policies in a prospec-
tus. These policy guidelines amount to constraints on the ability to choose portfolios freely.

Tax Considerations
Tax consequences are central to investment decisions. The performance of any investment
strategy should be measured by its rate of return after taxes. For household and institutional
investors who face significant tax rates, tax sheltering and deferral of tax obligations may be
pivotal in their investment strategy.

Unique Needs
Virtually every investor faces special circumstances. Imagine husband-and-wife aeronautical
engineers holding high-paying jobs in the same aerospace corporation. The entire human cap-
ital of that household is tied to a single player in a rather cyclical industry. This couple would
need to hedge the risk of a deterioration in the economic well-being of the aerospace industry.

In many cases, it is impossible to know the liquidity of an asset with certainty until it is put up for sale. In dealer mar-
kets (described in Chapter 3), however, the liquidity of the traded assets can be observed from the bid“ask spread that
is quoted by the dealers, that is, the difference between the “bid” quote (the lower price the dealer will pay the owner)
and the “ask” quote (the higher price a buyer would have to pay the dealer).
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Essentials of Investments, Management Investment Process Companies, 2003
Fifth Edition

Looking to Lower Your Risk? Just Add More
If you need money at a certain time, this risk must
If you™re like a lot of investors these days, you™re look-
be factored into your asset allocation.
ing to make your portfolio “less risky.”
Liquidity risk: Another risk heightened by current
The way to do that is by adding more risk, or at least
tensions, it affects everything from junk bonds to for-
more types of risk.
eign stocks. If world events were to alter the flow of
That strange twist”adding more to get less”is why
money in credit markets or to close some foreign stock
risk is one of the hardest elements of investing to
exchanges for an extended period, your holdings in
those areas could be severely hurt.
The first rule in risk is the hardest for many investors
Political risk: This is the prospect that government
to accept: There is no such thing as a “risk-free
decisions will affect the value of your investments.
Given the current environment, it is probably a factor in
Avoiding one form of risk means embracing an-
all forms of investing, whether you are looking at stocks
other; the safest of investments generally come with the
or bonds.
lowest returns, while the biggest potential gainers bring
Societal risk: Call this “world-event risk.” It was evi-
larger potential losses.
dent when the first anthrax scares sent markets reeling
The primary risks in fund investing include the
briefly. Some businesses are more susceptible (airlines,
for example), though virtually all types of investing have
Market risk: This is the big one, also known as
some concerns here.
principal risk, and it™s the chance that downturn chews
Even after all of those risks, some investments face
up your money.
currency risk, credit risk, and more. Every type of
Purchasing power risk: Sometimes called “inflation
risk deserves some consideration as you build your
risk,” this is the “risk of avoiding risk,” and it™s at the
opposite end of the spectrum from market risk. In a
Ultimately, by making sure that your portfolio ad-
nutshell, this is the possibility that you are too conser-
dresses all types of risk”heavier on the ones you prefer
vative and your money can™t grow fast enough to keep
and lighter on those that make you queasy”you en-
pace with inflation.
sure that no one type of risk can wipe you out.
Interest-rate risk: This is a key factor in the current
That™s something that a “less risky” portfolio may
environment of declining rates, where you face poten-
not be able to achieve.
tial income declines when a bond or certificate of de-
posit matures and you need to reinvest the money.
Goosing returns using higher-yielding, longer-term
securities creates the potential to get stuck losing
ground to inflation if the rate trend changes again. SOURCE: Abridged from Charles A. Jaffee™s article of the same title,
Boston Sunday Globe, October 21, 2001. BOSTON SUNDAY
Timing risk: This is another highly individual factor,
revolving around your personal time horizon. Simply
put, the chance of stock mutual funds making money by GLOBE NEWSPAPER CO (MA). Reproduced with permission
over the next 20 years is high; the prospects for the of GLOBE NEWSPAPER CO (MA) in the format Textbook via
next 18 months are murky. Copyright Clearance Center.

Similar issues would confront an executive on Wall Street who owns an apartment near
work. Because the value of the home in that part of Manhattan probably depends on the vital-
ity of the securities industry, the individual is doubly exposed to the vagaries of the stock mar-
ket. Because both job and home already depend on the fortunes of Wall Street, the purchase of
a typical diversified stock portfolio would actually increase the exposure to the stock market.
These examples illustrate that the job is often the primary “investment” of an individual,
and the unique risk profile that results from employment can play a big role in determining a
suitable investment portfolio.
Other unique needs of individuals often center around their stage in the life cycle, as dis-
cussed above. Retirement, housing, and children™s education constitute three major demands
for funds, and investment policy will depend in part on the proximity of these expenditures.
Institutional investors also face unique needs. For example, pension funds will differ in
their investment policy, depending on the average age of plan participants. Another example
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Essentials of Investments, Management Investment Process Companies, 2003
Fifth Edition

17 Investors and the Investment Process

of a unique need for an institutional investor would be a university whose trustees allow the
administration to use only cash income from the endowment fund. This constraint would
translate into a preference for high-dividend-paying assets.
Table 17.2 summarizes the types of objectives and constraints that investors must face as
they form their investment portfolios. The nearby box also explores some of the issues that in-
teract with an investor™s particular situation. We turn next to an examination of the specific ob-
jectives and constraints of the major investor types.

We are now in a position to compare investors on the basis of their objectives and constraints.
The next two tables will show how we can apply the objective/constraint approach to the for-
mation of policies.

Table 17.3 presents a matrix of objectives for various investors. For mutual funds, the return
requirement and risk tolerance are said to be variable because mutual funds segment the

Objectives Constraints
TA B L E 17.2
Return requirements Liquidity
Determination of
portfolio policies Risk tolerance Horizon
Unique needs, such as:
Ethical concerns
Specific hedging needs

Type of Investor Return Requirement Risk Tolerance
TA B L E 17.3
Individual and personal trusts Life cycle (education, Life cycle (younger are
Matrix of objectives
children, retirement) more risk tolerant)
Mutual funds Variable Variable
Pension funds Assumed actuarial rate Depends on proximity
of payouts
Endowment funds Determined by current Generally conservative
income needs and need
for asset growth to
maintain real value
Life insurance companies Should exceed new money Conservative
rate by sufficient margin
to meet expenses and
profit objectives; also
actuarial rates important
Non-life-insurance companies No minimum Conservative
Banks Interest spread Variable
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Fifth Edition

610 Part SIX Active Investment Management

investor market. Various funds appeal to distinct investor groups and will adopt a return re-
quirement and risk tolerance that fit an entire spectrum of market niches. For example, “high-
income” funds cater to the conservative investor, while “high-growth” funds seek out the more
risk-tolerant ones. Tax-free bond funds segment the market by tax obligation.
Pension funds must meet the actuarial rate; otherwise, the corporation sponsoring the plan
will need to make additional contributions. Once a pension fund™s actuarial rate is set, it es-
tablishes the fund return requirement, and additional risk tolerance becomes very low.
Endowment funds are classified as having “conservative” risk tolerance on the basis of ob-
servation, although individual institutions can differ in investment policy.
Life insurance companies have obligations to whole-life policyholders that are similar to
those of pension funds. These obligations require them to earn a minimum rate (analogous to
the pension fund™s actuarial rate), if the company is to meet its liabilities.
Banks earn profit from the interest rate spread between loans extended (the bank™s assets)
and deposits and CDs (the bank™s liabilities), as well as from fees for services. Managing bank
assets calls for balancing the loan portfolio with the portfolio of deposits and CDs. A bank can
increase the interest rate spread by lending to riskier borrowers and by increasing the propor-
tion of longer-term loans. Both policies threaten bank solvency though, so their deployment
must match the risk tolerance of the bank shareholders. In addition, bank capital regulations
now are risk-based, so higher-risk strategies will elicit higher capital requirements as well as
the possibility of greater regulatory interference in the bank™s affairs.


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