Chapter 3: The Investment Process

Question 1

3.1 The Investment Policy Statement (IPS)

Answer 1

• Different investors have different strategies. We describe here strategies that are commonly pursued and their relationship with investors constraints and objectives.
• Fundamental Question: Why invest at all?
• We invest now to have more later, the investment strategy depends on: 1. willingness to bear risk, 2. time horizon, and taxes.

Question 2

3.1 The Investment Policy Statement (IPS): Objectives & Constraints

Answer 2

1. Objectives:
   * Fundamental decision for an investor: how much risk to bear?
   * Risk-averse investor: dislike risk and want to expose themselves to minimum risk possible. Risk tolerance is the first thing that must be assessed evaluating suitability of an investment strategy.
2. Constraints:
3. Resources: Most common constraint, with no money you cannot invest. Minimum resource level needed.
4. Horizon: Planned life of an investment (retirement for example).
5. Liquidity: An asset with high degree of liquidity is one that can be sold quickly without a significant price concession. Liquidity has 2 related dimensions, and it is difficult to measure precisely. The less you lose when you sell an asset, the more liquid.
6. Taxes: The way an investment is held can dramatically affect its tax status. Taxes impact almost every step of investment process, from the type of account to the nature and length of investments.
7. Unique (Special) Circumstances.

Question 3

3.1 The Investment Policy Statement (IPS): Strategies & Policies

Answer 3

Strategies and policies: Once the Investment Policy Statement is in place, investors must determine the appropriate strategies to achieve the objectives. Investors need to address 4 key areas when they decide their investment strategy.

1. Investment Management: Basic decision for an investor, decide to manage or hire someone to do it.
2. Market Timing: Buying and selling in anticipation of the overall direction of a market.
3. Asset Allocation: Distribution of investment funds among classes of assets. How much to invest in common stocks and bonds is an important asset allocation decision. Rule of thumb: split 60% stocks 40% bonds.
4. Security Selection: Selection of specific securities within a particular class.
   ▸Active strategy: try to identify stocks that will do the best in the future.
   ▸Security Analysis: investigating particular securities within a broad class to identify superior performers.
   ▸Passive Strategy: acquire diverse group of stocks, perhaps by buying mutual fund that holds shares in several companies.
   ▸Distinguish asset allocation (macro-level activity, focus is on whole market or classes of assets) from security selection (micro-level, focus is on individual securities).

Question 4

3.2 Investment Professionals: Kinds of Broker/Advisor.

Answer 4

• Broker/Advisor: 3 different kinds of brokers, what distinguish them is: 1. Level of service they provide and 2. Commissions they charge.
  a. Full service broker: investment advice regarding securities and investment strategies. Larger brokerage firms do extensive research on individual companies/securities and maintain lists of recommended securities, and they have offices throughout the country.
  b. Deep-discount broker: only account maintenance and order execution (buying/selling).
  c. Discount broker: more investment counselling than deep-discount brokers, and lower commissions than full-service brokers.

Question 5

3.2 Investment Professionals: Investment Fraud.

Answer 5

Investment Fraud:
*Canadian Investor Protection Fund (CIPF): Created in 1969. The CIPF insures accounts for up to $1 million for losses of securities, commodity, and future contracts, segregated insurance funds and cash. CIPF is not a government agency; it is a private insurance fund supported by the securities industry. Almost all brokerage firms are members of the CIPF. The CIPF does not guarantee the value of any security. Rather, it protects whatever amount of cash and securities that were in the account, in the event of fraud or other failure.

Question 6

3.3 Types of Accounts

Answer 6

1. Cash Accounts: A brokerage account in which all transactions are made on strictly cash basis (simplest arrangement), if additional purchases are desired, then the needed funds must be supplied.
2. Margin Accounts: A brokerage account in which securities can be bought and sold on credit.
   ▸Margin purchase: purchase securities on credit using money loaned by brokers.
   ▸Call money rate: interest rate brokers pay to borrow bank funds for lending to customer margin accounts.
   ▸Margin: portion of the value of an investment that is not borrowed (amount that is yours).
   ▸Initial Margin: minimum margin that must be supplied on a securities purchase.
   ▸Maintenance Margin: minimum margin that must be present at all times in a margin account. Sometimes called the “house” margin requirement.
   ▸Margin Call: demand for more funds that occurs when margin in an account drops bellow maintenance margin.
   * Account Equity = Current value of stock - amount borrowed.
   * Margin % = Account Equity/Value of asset.
   * Critical Value P = (amount borrowed/# shares)/(1 - maintenance margin).

Question 7

3.4 Types of Positions

Answer 7

Once the Investment Policy Strategy is created and decided which type of investment professional will be employed, it is necessary to determine the types of positions to be hold in the account. 2 basic positions: 1. Long and 2. Short.
▸Long in the stock/Long position: investor who buys and owns shares of stock. A long investor hopes that the price will increase. Buy low, sell high.
* Short Sale: Sale in which the seller does not actually own the security that is sold. An investor with a short position benefits from price decreases. Sell high, buy low.