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Session Plan

1. Understand the individual investor life cycle

Investment Policy Statement (IPS)
Dr M Kannadhasan
Professor of Finance
Indian Institute of Management Raipur
2. Develop objectives and constraints
A. Our focus will be on developing return and risk objectives
B. The objectives and constraints allow us to assign initial asset
allocations
3. Introduction to asset allocation
A. Description of asset classes
B. Importance of asset allocation

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Portfolio management process Why IPS Important?

Provides a linkage between the client, managers, and investment

Planning Step
• Understanding client needs portfolio
• Preparing an investment policy
statement (IPS)
Serves as a structure decision-making process for clients and
advisors and helps to balance return seeking and risk taking
Offers clarity and generally helps to build a higher level of trust
between client and advisor
Feedback Step Execution Step
• Portfolio monitoring and • Asset allocation To satisfy the regulatory requirements and fiduciary standards of
rebalancing • Security analysis
• Portfolio measurement and
reporting
• Portfolio construction
care and client protection (suitability and fair dealing)

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Preparation of IPS
Major Components of IPS

Situational profiling
Psychological profiling
Introduction

Statement of Purpose

Statement of Duties and Responsibilities

Procedures

Investment Objectives

Investment Guidelines

Evaluation and Review

Appendices

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Situational Profiling Sources of Wealth (1)

✦ Active versus Passive Wealth

✦ Places clients into categories according to stage of life and economic
✦ Active wealth creators many have above average willingness to take
circumstances
risk
✤ to understand an investor’s basic philosophy, attitude, and
✤ Typically they are self-made investors and entrepreneurs are
preferences familiar with and confident in taking risk
✦ Three forms of situational profiling may offer insight into the client ✤ if things go wrong, they may have the confidence they can make it
attitude towards risk: back
✤ Sources of Wealth ✤ They may have difficulty in giving control to investment manager
✤ Measure of Wealth ✦ Passive recipients of wealth are typically less willingness to take risk:
✤ Stages of Life ✤ Generally wealth attained through inheritance, windfalls, long
steady employment, etc.
✤ Might have less experience and less understanding of risk and
return
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Measure of Wealth (2) Individual’s Life Cycle (3)

✦ Foundation Phase
✦ There is a positive relationship between clients perception of wealth
✤ Early career
and their willingness to take investment risk.
✤ Accumulation of education, developing skills
✦ Subjective assessment of financial well-being based on perceived
wealth versus needs ✤ Long-time horizon

✦ Generally, clients who perceive their wealth as small are less willing ✤ theoretically above average ability to take risk , but other

to take risk, wish to hold only low-volatility investments. considerations may intrude
✤ Few investable assets
✦ Accumulation Phase
✤ Early middle years of working career
✤ income rising and asset growing
✤ Longer time horizon affords individuals in this phase to take more risk

✤ Likely above-average ability to take risk

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Individual’s Life Cycle (3) Individual’s Life Cycle

✦ Consolidation Phase
✤ Past midpoint of careers

✤ Earnings greater than expenses

✤ Still long time horizon but capital preservation becomes more important
✦ Maintenance Phase

✤ Begins after retirement

✤ Capital preservation and inflation protection are very important

✤ Risk tolerance could be high and short time horizon

✦ Distribution Phase
✤ Focus shifts to wealth transfer

✤ risk tolerance is very high

✤ Tax constraints and transfer strategies often become important
consideration.
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Psychological Profiling Risk Aversion versus Loss Aversion

✦ Psychological profiling or personality profiling can help the

portfolio manager bridge the gap between the traditional finance ✤ example: given a choice between
focus on what rational people should do and behavioural finance (1) a small known gain of Rs. 800 and
focus on how people actually behave:
(2) a 50/50 chance of gain Rs. 1 ,600 or $0
Traditional finance Assumes Behavioural Finance assumes

Risk aversion Loss Aversion

Rational Expectations Biased Expectations

Asset Integration Asset Segregation

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Risk Aversion versus Loss Aversion
.
✤ example: given a choice between
(1) a small known loss of Rs. 800 and
Risk Aversion versus Loss Aversion
✦ Risk averse investors always minimise the risk for a given level of
return or maximise return for a given level of risk and measure risk
as volatility.

(2) a 50/50 chance of losing Rs. 1 ,600 or $0
✦ Loss averse investors are more focused on avoiding losses than on
maximising return. In addition, faced with a loss they will frequently
choose less certain (more risky) alternative, but faced with a gain
they choose the less risky alternative.
✤ Phrased as a gain, they take certainty, which is consistent with
traditional finance.
✤ Phrased as a loss, they take uncertainty, hoping to avoid a loss,
hence the term loss aversion.

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Asset integration versus Segregation Rational versus Biased Expectations

✦ Integration says investors should analyse the effect of any decision on the total
portfolio (considering diversification) and optimise total portfolio return for
risk taken.
✤ Investors consider the correlation of a potential investments with their
existing portfolios. They focus on the impact of adding a new asset on the
return and risk of the total portfolio.
✦ Rational investors make unbiased decisions and learn from their
mistakes
✦ Biased expectations imply that do not use all relevant information
and learn from their mistakes but instead put too much confidence
on their abilities to forecast economic events related to investments.

✦ Segregation recognises investor may view assets as being in separate accounts

dedicated based on the frame of reference in which the decision is presented.
✤ Investors view assets in isolation and do not consider the effect of
correlation with other assets. As a result:
Asset prices will reflect both underlying economics and the investors’
subjective feelings
Portfolio construction will be segmented by layers reflecting the priority
of its goals to that investors. Assets will be selected by Layer.
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Summary: TF vs BF Investor Personality Types

✦ Traditional finance: ✦ Generally, two approaches to personality classification exist:

✤ Asset prices are based on economic fundamentals ✤ Ad hoc evaluation by the investment advisor, who categories the
investor based on personal interviews and a review of past
✤ Portfolios are built considering correlation and diversification
investment activity.
effects to meet client objectives and constraints
✤ Short client questionnaires to gain insight into the investor’s
✦ Behavioural finance:
propensity to accept risk and the decision-making style used in
✤ Asset prices reflect hopes, fears, and other subjective factors as pursuing investment returns. These questionnaires address
well as economics investment topics but may also include self-evaluative statements
that have no direct investment context.
✤ Portfolios are build in layers of a pyramid to meet specific goals
and constraints.

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Investor Personality Types (Contin.) Cautious Personality Types (1)

✦ Based on the risk tolerance and decision making style, Clients can be ✦ Higher risk aversion/low risk tolerance
categorized as
✤ Emotionally focused on financial security, low volatility, and
✤ Cautious avoiding losses
✤ Methodical ✤ Reluctant to make decision or to consult others
✤ Individualistic ✤ Out of fear, they tend to overanalyse or do nothing

✤ spontaneous ✤ Portfolios tend to have low turnover and volatility

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Methodical Personality Types (2) Individualistic Personality Types (3)

✦ Higher risk aversion/low risk tolerance
✤ Relies on thinking and hard facts
✤ undertake research on trading strategies
✤ Continually seek new information, databases, and ideas
✤ No emotional attachment to their investments
✦ Lower risk aversion/high risk tolerance
✤ Independent thinkers who collect facts, work hard, and may do
their own research
✤ No afraid to exhibit investment independence in taking a course of
action.
✤ Have confidence in their ideas
✤ Are confident in their ability to achieve their long-term
investment objective.

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Spontaneous Personality Types (4) Investor Personality Types - Summary

✦ Lower risk aversion/high risk tolerance

Decisions based on primarily
✤ Continually adjust the portfolio based on feels about the market
on thinking on feeling
Risk aversion
✤ They fear falling behind or missing trends
More Methodical Cautious
✤ They admit they are not experts but doubt other’s ability

✤ Their portfolios are often over-managed with high turnover and

trading costs leading to lower returns. Less Individualist Spontaneous

Personality Traits Cautious Methodical Individualist Spontaneous

Conservative Moderate Aggressive

Model Portfolios

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Investment Policy Statement Investment Objectives

✦ The investment policy statement is a road map that: ✦ The primary objectives that need to be addressed in contracting an
IPS are the client’s risk and return objectives.
✤ specifies investment goals and acceptable risk levels
✦ These objectives can be stated in qualitative and quantitative terms
✤ should be reviewed periodically
✤ For example - a qualitative return objective may be to “provide
✤ guides all investment decisions
adequate retirement income’.
✦ The need for an IPS
✤ A qualitative risk objective or assessment may be to find that the
✤ Helps investors understand their own needs, objectives, and investment client can tolerate a moderate level of risk
contrasts
✦ For asset allocation purposes, a quantitative specification of return
✤ Set standards (bench mark portfolios) for evaluating portfolio and risk objectives are more useful.
performance
✤ Reduces the possibility of inappropriate behaviour on the part of the
portfolio manager
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Return Objectives (1) Return Objectives (2)

✦ Capital Preservation ✦ A Complete return objective will list the client’s objectives which
may include required (high priority goals of the client) and desired
✤ maintenance of the purchasing power of their investment
objectives
✦ Capital appreciation
✤ Required expenditures are those that the individual is obligated to
✤ growth of the portfolio in real terms to meet future need make - (living expenses, medical expenses, and educational
expenses)
✦ Current Income
✤ Desired expenditures are those that are voluntary - (vacation
✤ focus is in generating income rather than capital gains homes, expensive vacations, and large charitable contributions)
✦ Total return ✦ Quantify the investable asset base for the start of the return period
✤ focus is on increasing portfolio value through capital gains and ✦ Quantify the needed return (usually based on the required objectives)
reinvestment of current income
✦ Pay close attention to directions regarding pre-or post tax and real or
nominal return.
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Return Objectives (3) Return Objectives (3)

✦ Calculating after-tax return objective:
✤ after tax return = Projected Expenditure ÷ Investable assets
✤ After-tax Nominal return = (1+After tax Real Required return) +
(1+ Current inflation rate in %) -1
✦ A simple additive formulation of the absolute return objective is a
good starting point
✦ However, the effect of compounding and of expenses should be
incorporated in stating a IPS return objective:
Return = (1+ Spending Rate) (1+ Exp. inflation rate) (1+ Investment Expenses)

✦ Multiperiod considerations:
✦ If a client’s return objective is stated as an arithmetic mean annual return objective,
but return is based on the compound rate of return on the portfolio, the objective
should be adjusted upward to reflect the fact that arithmetic returns required to
achieve a goal are higher than returns stated as a compound rate. The adjustment
should be based on the following approximation
Compound Growth Rate = E(Arithmetic return) - 0.5* Variance
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Risk Objectives (1) Risk Objectives (2)

✦ Risk Objectives ✦ Risk Objectives

✤ Investor’s willingness to take risk
✤ Investor’s ability to take risk: The ability to take risk is a function
This is a qualitative statement based on the client’s risk tolerance. of:
The risk tolerance is based on his ability and willingness to take Required spending needs ( a modest requirements in relation to
on risk and is a function of: financial assets increase ability)
• Psychological profile (personality type)
Long-term wealth target increase ability
• current wealth
Financial strength
• Age Liabilities
• Past life experiences of the client
A need to cover inflation may require more risk
• Investment actions of the client
a lower liquidity needs increase ability
• Concerns with shortfall risk
• Actions speak louder than words

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Risk Objectives (3) Risk Tolerance Questionnaire

1.Personality Type
2.Self Esteem
3.Inclination for independent thinking

Willingne 1.Time Horizon

ss to take Ability to 2. Expected Income
take risk 3. Wealth relative to liabilities
risk
4. Age

Risk
Tolerance

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Risk Objectives (3) Risk Objectives (4)

✦ A client’s risk objective can be quantified in a number of ways:

✤ Mean Variance Utility

✤ Maximum acceptable SD
✤ Shortfall risk
✦ If there is a conflict between ability and willingness, state it and the
opportunity for further discussion with the client.
✦ The conclusion is generally the more conservative of the two.

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Risk Objectives (5) Risk Objectives (6)

✦ Mean Variance Utility ✦ Shortfall- risk

✤ based on the client’s risk aversion, the asset mix with the highest ✤ the risk that a portfolio’s value/return, E(Rp), will fall below some
expected utility for the client is optional. minimum acceptable value/return, (RL ), during a stated time
horizon.
✤ We can use Roy’s safety first criterion to evaluate portfolios based
on shortfall risk.
✤ Guidelines
• 1 ≤ Risk aversion ≤ 2 high risk tolerance
✤ It indicates that an optimal portfolio minimises the probability that
• 3 ≤ Risk aversion ≤ 5 Moderate risk tolerance the actual return will fall below the target return.
• 6 ≤ Risk aversion ≤ 8 Low risk tolerance ✤ The portfolio with highest SF ratio is optimal.

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Investment Constraints Investment Constraints (1)

✦ Liquidity needs ✦ Liquidity needs

✦ Time Horizon ✦ It has multiple interpretation in the context of the IPs

✦ Tax Concerns ✦ a difference between portfolio cash inflow and outflow

✦ Legal and regulatory ✦ One-time positive or negative liquidity events

✦ Unique Circumstances ✦ Ease of selling illiquid assets

✦ ongoing expenses
✦ Emergency reserve
High liquidity needs may reduce ability to take risk.

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Investment Constraints (2) Investment Constraints (3)

✦ Time Horizon ✦ Tax Concerns

✦ It can be single-stage or multi-stage. A stage is defined by a ✦ Ordinary income tax (flat or progressive)
known, significant change in client circumstances or ✦ Investment income tax: may be favourable
objectives.
✦ Interest income
✦ Each stage will likely affect the return objectives
✦ Dividends
✦ as a general rule, more than 10-15 years is considered long
✦ Capital Gains
term and less than 3-years is considered short term.
✦ Wealth Transfer Tax
✦ Shorter time horizons reduce ability to bear risk and longer
time horizons may allow for more risk. ✦ Legal ways to maximise after-tax return is the goal.

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Investment Constraints (3) Investment Constraints (3)

✦ Tax Concerns (cont’d) ✦ Tax Concerns (cont’d)

✦ Tax deferred Vs Tax-exempt: ✦ any amount of taxes not paid remains in the account to earn
✦ Compare when the taxes are paid: future (compounded) return:

✦ With taxes exempt, taxes paid at time t= 0 ✦ Low current income (e.g.equities) - Hold in taxable account

✦ With taxes deferred, taxes paid at time t=N ✦ High current income (e.g. Bonds) - Hold in tax protected a/c
✦ Ceteris paribus, difference in final “spendable cash” is due to
differences in the current tax rate and the expected future tax rate:
✦ Tax rate is lower today - use tax-exempt
✦ Tax rate is lower in future - use tax deferred
✦ Not expected to change - use either

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Investment Constraints (4) Investment Constraints (5)

✦ Legal and regulatory factors ✦ Unique circumstances

✦ The Personal trust: Revocable or irrevocable ✦ Any other item that would affect portfolio management and
does not fit elsewhere needs to be recorded. some examples:
✦ The individual is an insider or otherwise restricted in some
action ✦ Constraints against certain investments or socially
✦ In a trust situation, the manager generally takes on a fiduciary responsible investing (SRI)
duty: Income versus remainder beneficiaries ✦ Unusual requests
✦ Planned gifts

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Investment Constraints - Risk Tolerance Asset Allocation

Constrants Key Issue

✦ Asset allocation is the allocation of investable funds across asset
Higher liquidity requirements mean lower risk classes that are IPS- permissible based on the objectives and
Liquidity
tolerance constraints of the client.
Length affects the ability to take risk and asset
Time horizon ✦ An investment strategy is based on four decisions:
allocation
✤ what asset classes to consider for investment?
Tax Important for an Individual investors
✤ what normal or policy weights to assign to each eligible class?

Legal/Regulatory Important for Institutional Investors ✤ determine the allowable allocation ranges based on policy weights

Unique Circumstances e.g. individual investor with special needs ✤ what specific securities to purchase for the portfolio?

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Asset Allocation Asset Allocation: Selection of Asset Classes

✦ Strategic Asset Allocation ✦ Criteria to specify asset classes:

✤ Approaches to investing ✤ Assets within an asset classes should be relatively homogenous
Passive investment strategies ✤ Asset classes should be mutually exclusive
Active investment Strategies
✤ Asset classes should be diversifying (correlation should be less
Semi-active (risk controlled, or enhanced index strategies) than 1)
Capital Market Expectations: ✤ As a group, asset classes should make up a preponderance of
IPS: Objectives and
Expected return, variances, world investable assets
Constraints
covariance's

Strategic Asset Allocation: Optimal

portfolio from efficient frontier
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Asset Allocation: Asset Classes Topic of the Next Class

✦ Domestic equity - it can be further classified by style

✦ Capital Market Formation
✦ Domestic fixed income - It can be broken down by
government/corporate or by maturity

✦ Non-domestic equity - It can be broken down by developed and

developing
✦ Non-domestic fixed income

✦ Real Estate
✦ Alternative Investments
✤ Private equity, natural resources, hedge funds.

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Thank you

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