Essentials of Investments

© 2001 The McGraw-Hill Companies, Inc. All rights reserved.

Fourth Edition

Irwin / McGraw-Hill

Bodie • Kane • Marcus1

Chapter 5

Investors and the Investment Process

Essentials of Investments

© 2001 The McGraw-Hill Companies, Inc. All rights reserved.

Fourth Edition

Irwin / McGraw-Hill

Bodie • Kane • Marcus2

Overview of the Investment Process

• Specify objectives

• Identify constraints

• Formulate an investment policy

• Monitor performance

• Reevaluate and modify portfolio as determined from monitoring

Essentials of Investments

© 2001 The McGraw-Hill Companies, Inc. All rights reserved.

Fourth Edition

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Bodie • Kane • Marcus3

Specifying Objectives: Individual Investors

Balance risk and return

Life Cycle is critical to the process of determining the risk/return trade-off

Younger investors - willing to bear more risk for higher returns

Older investors - willing to accept lower returns for lower risk

Essentials of Investments

© 2001 The McGraw-Hill Companies, Inc. All rights reserved.

Fourth Edition

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Specifying Objectives: Personal Trusts and Mutual Funds

• Personal Trusts– Determined by the individual for whom the

funds are being managed

• Mutual Funds– Varies with type of fund– Detailed in the prospectus

Essentials of Investments

© 2001 The McGraw-Hill Companies, Inc. All rights reserved.

Fourth Edition

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Specifying Objectives: Pension Funds and Endowments

• Pension Funds– Defined contribution - shifted to the individual– Defined benefit - depends on average time to

retirement of individuals

• Endowment Funds– Gifts to nonprofits are invested– Funds from the endowment used by the nonprofit

Essentials of Investments

© 2001 The McGraw-Hill Companies, Inc. All rights reserved.

Fourth Edition

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Specifying Objectives: Insurance Companies

• Life Companies– Investments are hedged against potential

claims of policy holders

• Non-Life Companies– Invest premiums not paid back to

policyholders for loss– Hedge against potential claims

Essentials of Investments

© 2001 The McGraw-Hill Companies, Inc. All rights reserved.

Fourth Edition

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Specify Objectives: Banks

• Sources of funds: deposits and borrowed funds

• Investment of funds: predominately in loans and fixed income securities

• Active in the securitized loan and asset markets

• Not active in equity except in the Trust Function

Essentials of Investments

© 2001 The McGraw-Hill Companies, Inc. All rights reserved.

Fourth Edition

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Investor Constraints

Liquidity - speed and ease with which as asset can be converted into cash

Investment Horizon - the planned liquidation date

Regulations - specific regulations that may apply to the investorPrudent Man RuleMutual Fund DiversificationCharitable contribution limits

Essentials of Investments

© 2001 The McGraw-Hill Companies, Inc. All rights reserved.

Fourth Edition

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Investor Constraints

Tax Considerations - special considerations related to tax position of the investor

Unique Needs- special considerations related to the underlying investors

Diversification requirements related to employment

Essentials of Investments

© 2001 The McGraw-Hill Companies, Inc. All rights reserved.

Fourth Edition

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Bodie • Kane • Marcus10

Investment Policy: Asset Allocation Decision

Individual - depends on life cycle

Younger Higher equity 75% Lower safe assets 25%

Older Lower equity 40% Higher safe assets 60%

Institutional - depends on objectivesExample - an all stock mutual fund would want nearly 100% in stock Sector or Region allocations

Essentials of Investments

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Investment Policy: Active or Passive

Active

Trying to secure better than average performance

Must balance returns and costs

Passive

Trying to get average returns rather than do better than the market

Mix of Passive and Active

Essentials of Investments

© 2001 The McGraw-Hill Companies, Inc. All rights reserved.

Fourth Edition

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Bodie • Kane • Marcus12

Taxes and Investment Strategy

Shelter Options

• Deferral of taxes on capital gains

• Tax Deferred Retirement Plan– IRA– 401(k)– Taxes are paid on the income from

retirement and not on returns from investment