Chapter 15: Choosing an investment strategy

Question 1

4 Definitions of Risk

Answer 1

• probability of default
• expected variability of return
• risk of underperforming compared with competitors
• probability of failing to achieve the investor’s objectives.

Question 2

3 items influencing risk appetite of an institution

Answer 2

• nature of the institution
• constraints of its governing body and documentation
• legal or statutory controls

Question 3

4 Main features of liabilities that influence investment strategy

Answer 3

• nature
• term
• currency
• degree of uncertainty in timing and amounts

Question 4

Nature of a liability

Answer 4

whether or not they are subject to inflationary increases.

Question 5

15 Key factors influencing investment strategy

Answer 5

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

Question 6

2 Main factors governing the institution’s preference for income or capital growth from their investments

Answer 6

• Tax

- Cashflow requirements

Question 7

Principal aim of an investing institution

Answer 7

To meet its liabilities as they fall due.

the overriding need is to minimise risk.

Question 8

5 Possible objectives of a fund

Answer 8

• 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

Question 9

Relative performance risk

Answer 9

The risk of under performing ones competitors

Question 10

4 Groups of people who decide on the risk tolerance of an institution

Answer 10

• trustees (of trusts)
• members (of DC pension funds)
• directors (of companies)
• donators (of charities)

Question 11

4 Common problems of switching large portfolios

Answer 11

• Shifting market prices
• Timing issues
• Dealing costs
• Capital Gains Tax liability crystallizes

Question 12

2 Different sets of liabilities to match simultaneously

Answer 12

• the liabilities that they need to meet on an ongoing basis

- a statutory basis for proving solvency

Question 13

6 Main factors an individual should consider in making investment decisions

Answer 13

• investment constraints
• practical considerations
• risks arising from the variability of market values
• returns from different asset classes
• cashflow requirements
• characteristics of their assets / liabilities

Question 14

Characteristics of individual’s investments and liabilities

Answer 14

Usually individual’s liabilities are predominantly real and domestic, so real domestic assets are preferable.

Question 15

Their cashflow requirements

Answer 15

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.

Question 16

Variability of market values

Answer 16

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.

Question 17

Returns from different asset classes

Answer 17

The best value investments are probably those that have specific tax advantages; it may also be necessary to consider any “feel-good” factors

Question 18

3 Investment constraints to consider for individual investment strategy

Answer 18

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.

Question 19

3 Practical considerations when considering individual direct investment strategy

Answer 19

• 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

Question 20

4 Easily-overlook forms of investment

Answer 20

• 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

Question 21

3 Main considerations when considering a personal investor’s financial position

Answer 21

• existing assets
• future income
• future spending

Question 22

Selecting assets that are a good value involve allowing for: (2)

Answer 22

• the expenses of dealing in the asset

- the individual’s tax situation

Question 23

Important factors influencing risk appetite (3)

Answer 23

• age (older people are more risk averse)
• wealth (richer people are more aggressive investors)
• dependents (more dependents => more cautious)

Question 24

High levels of future income & expenditure UNCERTAINTY will lead to a need for more: (2)

Answer 24

• liquid assets

- insurance