CH14 - Choosing an investment strategy

Question 1

Define risk in 4 ways

Answer 1

1. Probability of default
2. Expected variability of return
3. Risk of under-performing compared with competitors
4. Probability of failing to achieve the investor’s objectives
   The last definition is the most practical when considering investment strategy.

Question 2

The risk appetite of an institution will depend on (3)

Answer 2

1. The nature of the institution
2. The constraints of its governing body and documentation
3. Legal of statutory controls

Question 3

Factors influencing an institution’s investment strategy (16)SOUNDER TRACTORS

Answer 3

Liabilities:

1. The nature of the existing liabilities
2. The currency of the existing liabilities
3. The term of the existing liabilities
4. The level of uncertainty of the existing liabilities - both in amount and timing
5. Future accrual of liabilities

External/other:

6. Tax and expenses
7. Statutory, legal and voluntary restrictions on how the fund may invest
8. Accounting rules
9. Statutory valuation and solvency requirements
10. The strategy followed by other funds

Assets:

11. The size of the assets, both in relation to the liabilities and in absolute terms
12. The expected long-term return from various asset classes
13. The existing asset portfolio

Institution:

14. The institution’s risk appetite
15. The institution’s objectives
16. The need for diversification

[Tip: to help in remembering them, study the points listed above and divide them into four or five groups with an appropriate heading for each group.
i.e. liabilities (nature, currency, term and certainty),

Question 4

Factors influencing an individual’s investment strategy (5)

Answer 4

The main factors for individuals are similar to those for institutions but the balance between the factors and the details differ.
The main factors an individual should consider in making investment decisions are:
1. The characteristics of their assets and liabilities and matching cashflows.
- Usually their liabilities are predominantly real (ie linked to inflation) and domestic, so real, domestic assets are preferable.
- Consider when asset proceeds are required, ie when total expenditure exceeds other income and the extend to which they want their investments to provide income as opposed to capital gains.
2. Risk
- The stability of values should not be a major factor for long-term investment, however the short time horizon of many individuals can make stability of asset values seem important
- Diversification is important
3. Returns from different asset classes - considering:
- Any specific tax advantages
- ‘Feel - good’ factors
4. Investment constraints - investment is constrained by the level of risk the individual can take on, which may depend on:
- The level of excess assets of the individual
- The uncertainty of future income and outgo
- The risk appetite of the investor
5. Practical considerations, which include:
- If the level of assets are too low to allow direct investment in some assets
- The relatively high expenses incurred when investing small amounts
- A likely lack of investment expertise and information

Question 5

Institutional investment objectives (3)

Answer 5

The investment objective should be clearly stated and quantified where possible. 
It should encompass:
1. the permitted degree of risk
2. the required return
3. the cashflow timing

Question 6

Different objectives (3)

Answer 6

The objectives can be described in various ways:

1. Meet the liabilities as they fall due.
2. Prove that it will be able to continue to do so on an ongoing basis - this requirement may itself apply on both:
   - a realistic basis (internally imposed and assessed)
   - a statutory basis (imposed externally by the regulator)
3. Prove that it could do so on a discontinuance basis.

Question 7

What to consider when defining investment risk (3)

Answer 7

1. The time period being considered
2. Whether the returns are measured in real (i.e net of inflation) or nominal terms
3. The currency in which we measure returns