Chapter 15: Choosing an investment strategy Flashcards
4 Definitions of Risk
- probability of default
- expected variability of return
- risk of underperforming compared with competitors
- probability of failing to achieve the investor’s objectives.
3 items influencing risk appetite of an institution
- nature of the institution
- constraints of its governing body and documentation
- legal or statutory controls
4 Main features of liabilities that influence investment strategy
- nature
- term
- currency
- degree of uncertainty in timing and amounts
Nature of a liability
whether or not they are subject to inflationary increases.
15 Key factors influencing investment strategy
S - Size of the assets, (in relation to liabilities and in absolute terms)
T - Tax and expenses (both treatment of the asset and the investor)
R - Risk appetite of the institution
E - Existing asset portfolio
S - Statutory valuation and solvency requirements
S - Strategy followed by other funds
E - Expected long-term return from various asset classes
D - Need for DIVERSIFICATION
F - Future Accrual of Liabilities
O - Objectives of the institution
R - Restrictions (statutory, legal or voluntary) on how the fund may invest.
T - Term of the existing liabilities
U - Level of UNCERTAINTY of the existing liabilities (both in amount and timing)
N - Nature of existing liabilities
E - Currency of Existing liabilities
2 Main factors governing the institution’s preference for income or capital growth from their investments
- Tax
- Cashflow requirements
Principal aim of an investing institution
To meet its liabilities as they fall due.
the overriding need is to minimise risk.
5 Possible objectives of a fund
- Meeting liabilities as and when they fall due
- Demonstrating solvency (on an ongoing, statutory and discontinuance basis)
- Minimising the burden on 3rd parties eg. trying to reduce the amount an employer has to contribute to a pension fund by taking aggressive investment strategy
- Maximise returns
- Outperform competitors
Relative performance risk
The risk of under performing ones competitors
4 Groups of people who decide on the risk tolerance of an institution
- trustees (of trusts)
- members (of DC pension funds)
- directors (of companies)
- donators (of charities)
4 Common problems of switching large portfolios
- Shifting market prices
- Timing issues
- Dealing costs
- Capital Gains Tax liability crystallizes
2 Different sets of liabilities to match simultaneously
- the liabilities that they need to meet on an ongoing basis
- a statutory basis for proving solvency
6 Main factors an individual should consider in making investment decisions
- investment constraints
- practical considerations
- risks arising from the variability of market values
- returns from different asset classes
- cashflow requirements
- characteristics of their assets / liabilities
Characteristics of individual’s investments and liabilities
Usually individual’s liabilities are predominantly real and domestic, so real domestic assets are preferable.
Their cashflow requirements
The individual should consider the period when their asset proceeds are required, ie when the total expenditure exceeds their income.
They should also determine the extent to which they want their investments to provide income as opposed to capital gains.
Variability of market values
Stability of values should not be a major factor for long-term investment, however the short-term horizon of many individuals can make stability of asset values seem important.
Returns from different asset classes
The best value investments are probably those that have specific tax advantages; it may also be necessary to consider any “feel-good” factors
3 Investment constraints to consider for individual investment strategy
Investment is constrained by the level of risk that an individual can take on, which may depend on :
- the level of excess assets of the individual, as these afford investment freedom
- the uncertainty of future income and outgo (cashflow matching) - individuals should ensure that they have sufficient liquid assets to meet fluctuations in day-to-day expenditure; having adequate insurance will help to ensure that emergency funds don’t need to be too big.
- the risk appetite of the investor.
3 Practical considerations when considering individual direct investment strategy
- the level of assets being too low to permit direct investment in some asset classes - the investor should ensure that there is adequate diversification overall
- the relatively high expenses incurred when investing small amounts
- a likely lack of investment expertise and information compared with professional investors
4 Easily-overlook forms of investment
- being a member of a pension scheme (individual or occupational)
- owning your own home
- an endowment assurance taken out to repay an interest-only mortgage
- money deposited in a bank
3 Main considerations when considering a personal investor’s financial position
- existing assets
- future income
- future spending
Selecting assets that are a good value involve allowing for: (2)
- the expenses of dealing in the asset
- the individual’s tax situation
Important factors influencing risk appetite (3)
- age (older people are more risk averse)
- wealth (richer people are more aggressive investors)
- dependents (more dependents => more cautious)
High levels of future income & expenditure UNCERTAINTY will lead to a need for more: (2)
- liquid assets
- insurance
