Chapter 2

Setting Portfolio Objectives

 Investment Clients
- After understanding the portfolio management process and
before discussing the portfolio objectives, it is important to
understand to whom the portfolio managers are employed or
contracted.
-We can group the clients into categories based on their
distinctive characteristics and needs:
1- Individual Investors
2-Institutional Investors
 Individual Investors

- Individual investors have a variety of motives for investing and

constructing portfolios:
1- Short-term goals can include providing for children’s
education, saving for a major purchase (such as a vehicle or a
house), or starting a business.
2- Long-term goals can include the retirement goal. Investing to
provide for an income in retirement is a major part of the
investment planning of most individuals. Many employees of
public and private companies invest for retirement through a
defined contribution (DC) pension plan.
 Individual Investors

-Individuals will invest part of their wages while working,

expecting to draw on the accumulated funds to provide income
during retirement or to transfer some of their wealth to their heirs.
The employee accepts the investment risk in the DC plan and is
responsible for ensuring that there are enough funds in the plan
to meet their needs upon retirement.
- Other individual investors gaols :Some individuals will be
investing for growth income and will therefore seek assets that
have the potential for capital gains. These investors may need
to draw an income from their assets and may therefore choose to
invest in fixed-income and dividend-paying shares.
 Institutional Investors

- There are many different types of institutional investors, such

as:
1- Defined Benefit Pension Plans
2- Endowments and Foundations
3- Banks
4- Insurance Companies
5- Investment Companies
 1- Defined Benefit Pension Plans

- In a defined benefit (DB) pension plan, an employer has an

obligation to pay a certain annual amount to its employees when
they retire
- DB plans need to invest the assets that will provide cash flows
that match the timing of the future pension payments (i.e.,
liabilities). Plans are committed to paying pensions to members,
and the assets of these plans are there to fund those payments.
- Plan managers need to ensure that sufficient assets will be
available to pay pension benefits as they come due.
 2- Endowments and Foundations

- Endowment is a donation of money or property to a nonprofit

organization, which uses the resulting investment income for a
specific purpose.
- For example, university endowments are established to provide
continuing financial support to a university and its students (e.g.,
scholarships).
 3- Banks
- Banks typically accept deposits and extend loans. But, in some
cases, banks need to invest their excess reserves (i.e., when
deposits have not been used to make loans).
- The investments of excess reserves need to be conservative,
emphasizing fixed-income and money market instruments
rather than equities and other riskier assets.
 4- Insurance Companies

- Insurance companies receive premiums for the policies they

write, and they need to invest these premiums in a manner that
will allow them to pay claims.
- Similar to banks, such investments need to be relatively
conservative given the necessity of paying claims when due.
- Life insurance companies and non-life insurance companies
(for example, auto and home insurance) differ in their purpose
and objectives and hence in their investment time horizons. Life
insurance companies have longer time horizons than non-life
insurance companies as a result of different expectations of
when payments will be required under policies.
 5- Investment Companies

- Investment companies that manage mutual funds are also

institutional investors.
- The mutual fund is a collective financial institution in which
investors pool their capital to have it invested by a professional
manager. The investors own shares or units in the fund.
- For many individual investors, the mutual fund is an efficient
means to benefit from portfolio diversification and the skill of a
professional manager.
 Who can manage the portfolio on
behalf the investor: Mutual Funds
- Rather than assemble a portfolio on their own, individual
investors and institutions can turn over the selection and
management of their investment portfolio to a third party through
a mutual fund.
- This type of fund is a combined investment pool in which
investors in the fund each have a pro-rata claim on the income
and value of the fund.
 Mutual Funds
- Mutual funds are one of the most important investment vehicles
for individuals and institutions. The best way to understand how a
mutual fund works is to consider a simple example:
- Suppose that an investment firm wishes to start a mutual fund
with a target amount of US$10 million. It is able to reach this goal
through investments from five individuals and two institutions.
The investment of each is as in the following slide:
 Mutual Funds

Based on the US$10 million value (net asset value), the investment
firm sets a total of 100,000 shares at an initial value of US$100 per
share (US$10 million/100,000= US$100). The investment firm will
appoint a portfolio manager to be responsible for the investment of the
US$10 million
 Mutual Funds
- The mutual fund can be set up as:
1- an open-end fund
2- a closed-end fund.
 Open-end fund

- If the mutual fund is an open-end fund, it will accept new investment

money and issue additional shares at a value equal to the net asset
value of the fund at the time of investment.
- For example, assume a new investor, F, wishes to invest US$0.96
million in the fund. If the total value of the assets in the fund is
US$10 million or US$100 per share, in order to accommodate the
new investment, the fund would create 9,600 new shares. Which is
the amount invested divided by value per share (US$0.96
million/US$100).
- After this investment, the net asset value of the fund would be
US$10.96 million (the net assets plus the new money invested) and
there would be a total of 109,600 shares.
 Closed-end fund.
- No new investment money is accepted into the fund. New
investors invest by buying existing shares, and investors in the
fund liquidate by selling their shares to other investors.
- Hence, the number of outstanding shares does not change.
 Types of Mutual Funds
1- Money Market Funds: are an investment fund consisting of a
portfolio of short-term corporate debt (e.g., bank loans) and
federal government debt.
2- Bond Mutual Funds: are an investment fund consisting of a
portfolio of individual bonds and, occasionally, preferred shares.
3- Stock Mutual Funds: are the largest types of mutual funds that
contain a portfolio of common stocks.
4- Hybrid/Balanced Fund : are mutual funds that invest in both
bonds and shares
 Setting Portfolio Objectives
- Setting objectives is important for every person and institution that uses the
financial market.
- Too many investors have a casual attitude toward financial planning,
including the management of their investment portfolios.
- It is easy for someone to be imprecise in communicating with the portfolio
manager. Fund managers often hear their clients say, in essence, “We want
a lot of return, we don’t want any risk, and we need the money by Monday.”
- The investor, therefore, should set his/her portfolio objectives to get a
successful investment program.
- -Two factors contribute to a successful investment program:
- 1- Suitable investment objectives and policy
- 2- Successful selection of the investment managers to implement policy.
- Generally, setting objectives is not an easy task!!!
 Why Setting
Objectives Can Be Difficult
- Semantics
- Indecision
- Subjectivity
- Multiple Beneficiaries
- Investment Policy versus Investment Strategy
 Semantics

- Growth, income, return on investment, and risk mean different

things to different people.
- e.g., a savings account provides income only; it has no growth
potential
- There must be a clear understanding of the terms when
entrusting money to a fund manager.
 Indecision
- The client’s or investor’s inability to make a decision.
- e.g., A bank customer wants the interest the account earned
sent home each month, but also wanted the interest
compounded. The bank obviously cannot do this. The customer
can spend the interest he earns, or he can leave it in the bank
and let it earn more interest, but he cannot do both.
 Subjectivity
- Subjectivity means that investors may decide their investment
decision based on influence of their personal beliefs or feelings,
rather than facts.
- A particular portfolio game plan may focus on “growth.” In
working toward this goal, the portfolio manager may choose to
include some common stock of AT&T Corp. in the portfolio. Many
people consider AT&T, or “Telephone,” as it is called among
investors, to be a growth stock. Others, though, would say that
Telephone is purely an income stock and does not logically
belong in a growth portfolio. This is a subjective call, and
disagreement is obviously possible.
 Multiple Beneficiaries
- Investment portfolios often have more than one beneficiary.
- An endowment fund is a good example. It has a perpetual life
and as such should benefit people today and people
generations from now.
- It is possible to increase current income from the portfolio
- Benefits today’s beneficiaries
- May be at the expense of future beneficiaries
-e.g., Social Security and federal unemployment insurance.
 Investment Policy versus Investment
Strategy
- Investment policy deals with decisions that have been made about long-
term investment activities, eligible investment categories, and the
allocation of funds among the eligible investment categories. For example,
pension fund decides never to place more than 30 percent in common
stock.
- Investment strategy deals with short-term activities that are consistent
with established policy and that will contribute positively toward obtaining the
objective of the portfolio. e.g., a manager may be required to maintain at
least 30 percent equity by policy but decides to put 50 percent in the stock
market because of a belief that the market will advance in the near future.
 Preconditions
- Before setting portfolio objectives, the portfolio manager should ask
him/herself some questions to assess the existing situation:
➢What are the current needs of the beneficiary: e.g., does the investor
need drastic, quick changes in the composition of the portfolio
(especially the level of income generated?
➢What is the investment horizon :At a pension fund, for instance, the
investment horizon is very long term. The ups and downs of the
market are not nearly as much a concern to a pension fund as they
are to an individual investor who is investing for a child’s college
expenses or for retirement income
➢Are there special liquidity needs?
➢Are there ethical investing concerns established by the fund’s owner
or overseer?
 Traditional Portfolio Objectives
1- Stability of Principal
2- Income
3- Growth of Income
4- Capital Appreciation
 Stability of Principal

- Sometimes the beneficiary of a portfolio cannot stand any chance of

loss to the original principal. This might be because of by law
provisions, statute, or the client’s attitude toward risk. When someone
says “I don’t want any chance of losing the money I invest,” the fund
manager should interpret this person’s objective as stability of
principal. This is the most conservative portfolio objective, and over
the long run, it will generate the most modest return.
- The emphasis here is on preserving the “original” value of the
fund.
-The investor who has the stability of principal objective does not want
to take any risk investment.
 Income
- The income objective differs from stability of principal in that there is no
specific proscription against periodic declines in principal value.
- For example, treasury notes may experience a decline in value if interest
rates rise, but the investor will not experience a loss if he holds the note to
maturity. If the bondholder finds it necessary to sell them prior to maturity,
however, the sale could easily result in a loss.
- When income is the chosen objective, appropriate investments include:
➢ Corporate bonds
➢Government bonds
➢Government agency securities
➢Preferred stock,
➢Common stock.
 Growth of Income
• This objective often seeks to have the annual income increase by
at least the rate of inflation.
• Why: Dollars today are worth more than an equal number of dollars
at any point in the future due to the inflation.
• Example:
• Suppose that over the next twenty years the average inflation rate
turns out to be 4%. In today’s dollars, $600 to be received in twenty
years is worth only $274 as the present value of this amount is
$600/(1.04)^20. Its purchasing power is less than half the original
$600 amount.
• Why this occurs: the purchasing power of the money decreases as
the inflation increases.
 Capital Appreciation
- It is not important that a portfolio generate any income at all. A
retired couple, for instance, might receive pension and Social
Security checks that are sufficient to finance their retirement
lifestyle. If these people have an investment portfolio, they
might be more interested in having it continue to grow in value
rather than in getting additional income from it. Their objective is
capital appreciation. Their intent may be to leave most of their
estate to children and grandchildren.
- This objective ,therefore, is for the portfolio to grow in value
rather than generate income. Appropriate for investors who
have no income needs.