As discovered in the previous post, the first step of the five steps of the investment process in the investment policy. In this step, one has to do the following;
- –Identify investor’s unique objective
- –Determine amount of investable wealth
- –State objectives in terms of risk and return
- –Identify investment and legal constraints
- –Identify potential investment categories
Unique Needs and Preferences
- Personal preferences such as socially conscious investments could influence investment choice
- Time constraints or lack of expertise for managing the portfolio may require professional management
- Large investment in employer’s stock may require consideration of diversification needs
- Institutional investors needs
- Capital preservation
–Minimize risk of loss
- Capital appreciation
–Growth of the portfolio in real terms to meet future needs
- Current income
–Focus on generating income rather than capital gains
- Liquidity needs
–Varies between investors depending upon age, employment, tax status, etc.
- Time horizon
–Influences liquidity needs and risk tolerance
- Tax concerns
–Capital gains or losses – taxed differently from income
–Unrealized capital gain – reflect price appreciation of currently held assets that have not yet been sold
–Realized capital gain – when the asset has been sold at a profit
–Trade-off between taxes and diversification – tax consequences of selling company stock for diversification purposes
Legal and Regulatory Factors
- Limitations or penalties on withdrawals (such as from an RBA)
- Investment laws prohibit insider trading
The Need For A Policy Statement; Why have a policy statement?
- Helps investors understand their own needs, objectives, and investment constraints
- Sets standards for evaluating portfolio performance
- Reduces the possibility of inappropriate behavior on the part of the portfolio manager
Constructing A Policy Statement
To effectively construct a policy statement, you have to ask yourself the following key questions and attend to them with due diligence.
- What are the real risks of an adverse financial outcome, especially in the short run?
- What probable emotional reactions will I have to an adverse financial outcome?
- How knowledgeable am I about investments and the financial markets?
- What other capital or income sources do I have? How important is this particular portfolio to my overall financial position?
- What, if any, legal restrictions may affect my investment needs?
- What, if any, unanticipated consequences of interim fluctuations in portfolio value might affect my investment policy?
Checkout the remaining four steps of the investment process.