Tools & Techniques of Investment Planning, 4th Edition

Stephan R. Leimberg

• Publisher: The National Underwriter Company
• Year: 2017
• ISBN:
  9781945424458
• Topic: Business
• Subtopic: Investments & Securities
• Index: Business

The Tools & Techniques of Investment Planning, 4th Edition helps practitioners demystify the process of investing by providing practical insights into the strengths and weaknesses of different investment approaches and asset classes, and highlights strategies for managing portfolios in the contemporary investment climate.

INTRODUCTION TO INVESTMENT PLANNING

CHAPTER 1

Both individual and institutional investors have a need to plan for the future. Investment planning plays a key role in making sure that these investors can achieve their goals and fulfill their missions. Investment planning is the process by which an investor or investment adviser plans for and manages an investment portfolio. This process is depicted in Figure 1.1

This continuous process begins with an initial assessment of the client and is accompanied by periodic reassessments in order to determine what adjustments, if any, are needed for the investment plan. In this chapter we will introduce each of the steps in the process and will provide the reader with a roadmap of the rest of the book.

CLIENT ASSESSMENT

The first step in the investment planning process is to assess the client and the client’s objectives, constraints and preferences. For an individual investor, you need to gain an understanding of their current financial, tax and family situation, their investment experience and their risk tolerance. Typical objectives include planning for retirement, education, or major purchases such as a home or college tuition. Some investors may have constraints in terms of how much liquidity they need to maintain and when funds need to be accessible in the future. Further, they may have preferences as to the types of securities they are comfortable holding. Institutional investors are legal entities that typically serve as intermediaries for money held for the benefit of others and include pension funds, foundations, endowments, insurance companies, banks, and some other financial intermediaries. Management of institutional funds requires an understanding of the nature of the entity, its investment policy, its tax status and its objectives.

Figure 1.1. Investment Planning Process

CAPITAL MARKETS ASSESSMENT

In addition to a thorough understanding of the client, investment planning requires an understanding of the current economic environment and an assessment as to how different types of investments (asset classes) are expected to perform in this environment (both from a risk and return standpoint). These expectations typically are set based upon the current market and economic environment but are done in the context of historical risk and return relationships.

STRATEGIC ASSET ALLOCATION

Once the investment adviser has assessed the client and the capital markets the next step is to design an optimal or target portfolio for the client. This portfolio should be designed to provide sufficient return to meet the client’s various objectives while managing the risk to a level acceptable to the client. The most important concept in portfolio design is diversification—diversification among types of investments and individual investments within each type. There are a variety of types of investment alternatives that can be used to create a portfolio. Generally the more types of investments that are included in a portfolio the lower the risk of that portfolio. Further to that point, within each investment type the more individual securities that are included generally the lower the risk (up to a limit).

What types of investments can be included in a portfolio? We can capture the essence of the different types of securities into three core elements:

• Real Assets

• Ownership Interests in Businesses

• Debt Instruments

Real assets would include investments in hard assets such as real estate, commodities or even equipment. Returns on these assets might come from appreciation and/or income received from renting the asset to someone else. Ownership interests in a business could include partial or whole ownership of an unincorporated closely-held company or shares of stock in a large, publicly traded company. Returns may come from either distribution of earnings or price appreciation. Debt instruments represent loans made from the investor to another party for which the investor is promised both interest income for the use of the funds plus a return of principal. A variety of other investments can be devised that are variations of these core elements.

In the early days of investment planning, the main focus was on portfolios of publicly available fixed income securities (bonds) and equities (stocks)—representing the last two core elements. These investments are therefore often referred to as traditional investments or asset classes. Note that investments in real assets (such as real estate) predate the existence of stocks and bonds. Oddly, these assets are not classified as traditional investments and are instead today referred to by most market participants as alternative investments. There are a large variety of investment types available today and they are typically categorized into broad assets classes such as:

• Fixed Income Investments

• Equity Investments

• Derivatives

• Alternative Investments

Fixed income investments include cash, notes, bonds, guaranteed investment contracts and other, similar instruments. Equity investments generally include publicly traded common and preferred stock. Derivatives (such as options and futures on stocks, bonds or real assets) are financial instruments that offer a return based on the return of some other underlying asset. Alternative assets include real estate, commodities, asset backed securities, and nonpublicly traded equity investments (private equity and venture capital), among others. These broad asset classes are often split into subclasses. For example fixed income investment subclasses can include cash, government bonds, municipal bonds, and corporate bonds. Equity investment subclasses can include growth stocks, value stocks, small capitalization stocks, midcapitalization stocks, large capitalization stocks, international stocks and the like.

Strategic asset allocation is the process of determining which assets classes to include in a client’s portfolio and in what proportion. The strategic asset allocation is designed to meet long term objectives using long term risk, return and relationship expectations for the asset classes available in the capital markets and based on the client’s risk tolerance, time horizon and idiosyncratic preferences.

TACTICAL ASSET ALLOCATION

Tactical asset allocation is a short term adjustment (or tilt) to the long-term strategic asset allocation based on expected relative short-term performance of different asset classes. For example, a client may have a strategic asset allocation that calls for an allocation to long term government bonds of about 30 percent of the portfolio and the adviser expects a near term increase in interest rates based on an expected change in the monetary stance of central banks. The adviser may therefore reduce the current exposure to long term government bonds with the expectation of returning to the long term strategic allocation in the future. Often strategic asset allocation is expressed with ranges in order to permit such adjustments (for example, a policy of 25 to 35 percent in long term government bonds rather than a fixed 30 percent allocation).

SECURITY OR MANAGER SELECTION

Once it has been determined how much to invest in each asset class, the adviser then must determine what securities to purchase within a particular asset class. This is done using tools such as fundamental analysis, technical analysis or indexing. The investment adviser also may choose to use pooled investment vehicles such as mutual funds or ETFs or to select a money manager to manage the underlying securities.

MONITORING

Once an investment plan has been implemented with a strategic asset allocation and the underlying securities have been purchased, the adviser must continuously monitor the portfolio. This process involves an assessment of underlying securities or managers to make sure they are performing in line with expectations, to assess the impact of any major news or changes in economic conditions and so that periodic reports can be prepared for the client.

REBALANCING

Over time a portfolio’s percentage allocation to various asset classes will shift as asset classes perform differently. Rebalancing is the process of selling positions in an asset class that has outperformed and adding to positions asset classes that have underperformed to get back to the target strategic asset allocation. Rebalancing can be based on a calendar approach (for example, every quarter) or a corridor approach (for example, when an asset class strays plus or minus 5 percent from its target allocation).

PERFORMANCE EVALUATION

In addition to continuous monitoring, periodically the adviser should report to the client how the portfolio is performing. There are a variety of techniques for evaluating and reporting on performance such as return metrics, risk-adjusted return metrics and benchmarking. The process then starts over. Periodically the adviser must re-assess the client’s situation and capital market expectations and make any necessary adjustments to the long term strategic asset allocation. While adjustments to the long term allocation should only be made occasionally (every three to five years or so), the adviser should inquire about any changes in the client’s situation or objectives on at least an annual basis. If major changes in the client’s situation have occurred the long term plan should be revisited. Further, the strategic asset allocation should also be revisited more often if there are substantial changes in capital market expectations.

ORGANIZATION OF THIS BOOK

The remainder of this book presents the tools and techniques needed to successfully plan and manage investments for any institutional client or for the individual investor. In the Tools section we present the various asset classes presented above (fixed income, equity, derivatives and alternative investments) and the individual investments available within each of those asset classes. In addition we include chapters on pooled investments which aggregate assets within these assets classes (such as mutual funds, ETFs, hedge funds and structured products) and chapters on insurance products which have embedded within them these same asset classes (life insurance and annuities). Within each chapter in the Tools section we describe:

• what the investment is;

• when its use is indicated;

• the advantages;

• the disadvantages;

• tax implications;

• where and how to invest;

• fees;

• selecting the best types; and

• where you can find more information.

In the Techniques section of the book we show how these tools can be used to design portfolios for individual or institutional clients. We also show how risk and return is measured and how to evaluate the performance of securities and portfolios.

The appendices provide a variety of valuable tables for use in your practice ranging from present and future value tables to tax tables.

CASH AND CASH EQUIVALENTS

CHAPTER 2

INTRODUCTION

Investments in cash are not just the physical currency, but typically include investments in bank certificates of deposit, bank savings accounts, short-term United States Treasury issues, and money market mutual funds. The main goal of cash and cash equivalent investments is to preserve capital.

A Certificate of Deposit (CD) is a debt instrument issued by a commercial bank, savings and loan, credit union, or other thrift institution (herein collectively referred to as “bank”) in exchange for a deposit made by an investor. CDs are usually issued in minimum amounts of $5,000, but are increasingly available in smaller denominations. The term of these certificates can range from ...

Table of contents

• Cover 
• Title Page
• Copyright Page
• About The National Underwriter Company
• Dedication
• About The Authors
• About The Publisher
• Preface
• Table of Contents 
• Part I: Tools of Investment Planning
• Part II: Techniques of Investment Planning
• Appendices
• Glossary
• Index