CHAPTER 7

BASICS OF PORTFOLIO PLANNING AND CONSTRUCTION

Presenter
Venue
Date

REASONS FOR A WRITTEN INVESTMENT POLICY

STATEMENT (IPS)

Legal or
Regulatory
Requirements
Suitability of
an Investment

Governance
Arrangements

IPS

MAJOR COMPONENTS OF AN IPS

Introduction
Statement of Purpose
Statement of Duties and
Responsibilities
Procedures
Investment Objectives
Investment Guidelines
Evaluation and Review
Appendices

WHAT ARE THE DIFFERENT TYPES OF

RISK OBJECTIVES?
Risk Objectives

Absolute: Stated without context

Relative: A comparison

The 12-month 95% value at

risk (VAR) of the portfolio must
not be more than
1 billion.

Achieving a return within 4%

of the TOPIX return
approximately 95% of the
time.

HOW DOES THE WILLINGNESS TO TAKE RISK

DIFFER FROM THE ABILITY TO BEAR RISK?

Willingness to
Take Risk

Personality
type?
Self-esteem?
Inclination for
independent
thinking?

Ability to
Bear Risk

Risk Tolerance

Time horizon?
Expected
income?
Wealth relative
to liabilities?

EXHIBIT 7-1 MEASURING THE

WILLINGNESS TO TAKE RISK
1. Investing is too difficult to understand.
2. I am more comfortable putting my money in a bank account
than in the stock market.
3. When I think of the word risk, the term loss comes to
mind immediately.
4. Making money in stocks and bonds is based on luck.
5. In terms of investing, safety is more important than returns.
Possible responses for all five questions: (A) Strongly agree, (B)
Tend to agree, (C) Tend to disagree, and (D) Strongly disagree.
Source: Grable and Joo (2004).

EXAMPLE 7-2 THE CASE OF HENRI GASCON:

RISK TOLERANCE
Henri Gascon is an energy trader who works for a major
French oil company based in Paris. He is 30 years old and
married with one son, aged 5. Gascon has decided that it is
time to review his financial situation and consults a financial
adviser. The financial adviser notes the following aspects of
Gascons situation:
Gascons annual salary of 250,000 is more than sufficient
to cover the familys outgoings.
Gascon owns his apartment outright and has 1,000,000
of savings.
Gascon perceives that his job is reasonably secure.

EXAMPLE 7-2 THE CASE OF HENRI GASCON:

RISK TOLERANCE (CONTINUED)
Gascon has a good knowledge of financial matters and is
confident that equity markets will deliver positive returns
over the longer term.
In the risk tolerance questionnaire, Gascon strongly
disagrees with the statements that making money in
stocks and bonds is based on luck and that in terms of
investing, safety is more important than returns.
Gascon expects that most of his savings will be used to
fund his retirement, which he hopes to start at age 50.

HENRI GASCONS TOLERANCE FOR RISK

Ability to
Bear Risk

Willingness to
Take Risk

Knowledgeable
about financial
markets
Answers to
survey suggest
risk tolerance

Risk Tolerance

Secure job
High income
relative to
expenses
Significant assets
Time horizon of 20
years

WHAT ARE THE IMPORTANT CONSIDERATIONS

WHEN SETTING RETURN OBJECTIVES?

EXAMPLE 7-4 THE CASE OF HENRI GASCON:

RETURN OBJECTIVES
Having assessed his risk tolerance, Henri Gascon
now begins to discuss his retirement income needs
with the financial adviser. He wishes to retire at age
50, which is 20 years from now. His salary meets
current and expected future expenditure
requirements, but he does not expect to be able to
make any additional pension contributions to his
fund. Gascon sets aside 100,000 of his savings as
an emergency fund to be held in cash. The
remaining 900,000 is to be invested for his
retirement.

EXAMPLE 7-4 THE CASE OF HENRI GASCON:

RETURN OBJECTIVES (CONTINUED)
Gascon estimates that a before-tax amount of
2,000,000 in todays money will be sufficient to
fund his retirement income needs. The financial
adviser expects inflation to average 2% per year
over the next 20 years. Pension fund contributions
and pension fund returns in France are exempt
from tax, but pension fund distributions are taxable
upon retirement.

WHAT IS HENRI GASCONS RETURN

OBJECTIVE?
Gascons retirement needs:
2,000,000 (1 + 0.02)20 = 2,971,895
Gascons return objective:
900,000 (1 + x)20 = 2,971,895
x 6.20%

CONSTRAINTS ON PORTFOLIO
SELECTION
Portfolio
Selection

HOW DOES THE NEED FOR LIQUIDITY AFFECT SAMPO

GROUPS INVESTMENTS?
Allocation of Investment Assets,
Sampo Group
31 December 2008 (16,502 million)

Fixed-Income Investments by Type of

Instrument, Sampo Group
31 December 2008 (13,214 million)

Breakdown of fixed-income
investments

HOW THE INVESTORS TIME HORIZON

AFFECTS PORTFOLIO ASSET SELECTION

Portfolio
Asset
Selection

TAX CONCERNS AND LEGAL AND

REGULATORY FACTORS

UNIQUE CIRCUMSTANCES

EXAMPLE 7-7 HENRI GASCON:

DESCRIPTION OF CONSTRAINTS
Gascon expects that he will continue to work for the oil
company and that his relatively high income will continue for
the foreseeable future. Gascon and his wife do not plan to
have any additional children, but expect that their son will go
to a university at age 18. They expect that their sons
education costs can be met out of their salary income.

EXAMPLE 7-7 HENRI GASCON:

DESCRIPTION OF CONSTRAINTS (CONTINUED)
Gascons emergency reserve of 100,000 is considered to
be sufficient as a reserve for unforeseen expenditures and
emergencies. His retirement savings of 900,000 has been
contributed to his defined contribution pension plan account
to fund his retirement. Under French regulation, pension
fund contributions are paid from gross income (i.e., income
prior to deduction of tax) and pension fund returns are
exempt from tax, but pension payments from a fund to
retirees are taxed as income to the retiree.

WHAT ARE THE CONSTRAINTS ON HENRI

GASCONS RETIREMENT PORTFOLIO?

Liquidity: No need for liquidity.

Time Horizon: Approximately 20 years.
Tax Concerns: Portfolio is tax exempt.
Legal and Regulatory Factors: French pension
fund regulations.
Unique Circumstances: No significant exposure
to oil and other commodity stocks.

HOW ARE PORTFOLIOS CONSTRUCTED?

QUANTIFYING CAPITAL MARKET

EXPECTATIONS

STRATEGIC ASSET ALLOCATION (SAA)

Strategic asset allocation (SAA) is a means to providing the
investor with exposure to the systematic risks of asset
classes in proportions consistent with the IPS.

DEFINING AN ASSET CLASS

Are all of these
specifications
necessary?

EXAMPLE 7-9 SPECIFYING ASSET CLASSES

Asset class correlation matrix:

High-paired correlations between equity asset classes

suggest that defining equity asset classes narrowly has
limited value.
The case for treatment as a separate asset class can
best be made for emerging market stocks.

STEPS TOWARD AN ACTUAL PORTFOLIO

TACTICAL ASSET ALLOCATION AND SECURITY

SELECTION
Systematic
risk factors
Market return:
passive
investing or
indexing

Excess
return or
alpha: active
investing

Nonsystematic
risk factors

CAN SECURITY SELECTION ADD VALUE?

At the macro level,
security selection is a
zero-sum game.

What factors affect the ability to add

value via security selection?

REBALANCING POLICY

EXAMPLE 7-12 STRATEGIC ASSET

ALLOCATION FOR A EUROPEAN CHARITY

Key factors affecting rebalancing:

Ending weight of European equities.
Expectations regarding future asset class returns.

SUMMARY
Components of the IPS
Risk and return objectives
Determinants of risk tolerance
Investment constraints
Risk budgeting
Strategic asset allocation
Tactical asset allocation and security selection
Rebalancing policy