Chapter 22 – Investors and the Investment Process
CHAPTER TWENTY TWO
INVESTORS AND THE INVESTMENT PROCESS
CHAPTER OVERVIEW
This chapter discusses the objectives and constraints of various types of institutional investors
and provides an overview of the investment process from asset allocation to security selection.
The process begins with the development of goals and constraints. Example constraints, such as
liquidity needs are presented. Once these are determined, the parameters must be translated into
LEARNING OBJECTIVES
After studying this chapter the student should have an understanding of the risk/return tradeoff
and that investors have different levels of risk tolerance. The student should have a basic
knowledge of different types of institutional investors and the objectives and constraints they
face. As a result, the student should be able to compare and contrast major types of investment
policies, including the difference between passive and active strategies.
CHAPTER OUTLINE
1. The Investment Management Process
PPT 22-2 through PPT 22-5
Figure 22.1 and Table 22.1 provide an overview of the investment process. The first step in the
2. Investor Objectives
Chapter 22 – Investors and the Investment Process
PPT 22-6 through PPT 22-13
The most critical concern for an individual in setting objectives involves identification of the
appropriate trade-off between risk and return. This trade off will depend on the investor’s stage
in the life cycle. The appropriate balance between risk and return changes throughout an
investor’s life. As one ages their wealth shifts from human capital to financial capital, increasing
according to the goals in the prospectus. The objective of a pension fund is dependent on the
type of pension fund. With a defined benefit plan, where the plan sponsor is guaranteeing some
level of benefit based on the employee’s length of employment and salary, the policy will be
most heavily influenced by the average time to retirement of the individuals covered under the
plan. Defined benefit plans are typically heavily invested in equities. The higher expected rate of
term and pays nothing otherwise. Term insurance may be annual renewable, which is very
common in group plans, in which case premiums may rise each year or every few years. Term
insurance with level premiums for 5 and 10 years are also readily available. Term insurance
with reduced benefits over time (as dependents grow up) with level premiums is also available.
Most students will be offered term insurance as part of a benefits package from their employer.
carrot for these plans. In many plans the policyholder can also borrow at a low interest rate
against the cash value of the policy. There are variations of whole life policies including
variable life and universal life. Variable and universal life policies can offer different terms, but
generally they give the policyholder more flexibility in what they cash value is invested in the
size of the premiums and death benefit. Most conservative investors will prefer either term life
3. Investor Constraints
PPT 22-14 through PPT 22-17
Investors are subject to a variety of constraints that will impact their investment choices. The
major constraints that may affect investment include liquidity needs, the length of the investment
horizon, regulations, tax considerations and any unique needs. Liquidity is an important
consideration with high levels of uncertainty. Tax considerations can be critical to an individual
4. Investment Policies
PPT 22-18 through PPT 22-24
Large institutional investors need to be concerned about organizational efficiency. A top-down
policy involves identification of the asset universe by the highest levels of the organization and
follows with an approved list of investments for lower groups. The investment committee is
comprised of senior management. This committee formulates investment policies and verifies
5. Monitoring and Revising Investment Portfolios
PPT 22-25
Finally it is important for the investor to continually monitor the portfolio. By the time of
completion of investment steps, the inputs may be out of date, necessitating strategy revisions.