16.3 Step 1: Determine Investment Objectives And Constraints

Overview

Determining investment objectives and constraints is the crucial first step in establishing a personalized asset allocation for a client’s portfolio. Knowing a client’s goals help translate desires into feasible investment objectives while considering their unique constraints.

Key Components of Step 1

Investment Objectives

The primary investment objectives typically include:

1. Safety of Principal (or preservation of capital)
2. Income
3. Growth of Capital

Secondary considerations might include liquidity (ease of converting assets into cash) and tax minimization.

Investment Constraints

Constraints need to be identified and considered to ensure the portfolio aligns with the client’s reality and goals. Common constraints include:

1. Time Horizon
2. Liquidity Requirements
3. Tax Considerations
4. Legal and Regulatory Constraints
5. Unique Circumstances

Detailed Analysis

Return and Risk Objectives

To craft a sound investment strategy, it is essential to answer:

1. What rate of return does the client need?
2. What risk is the client willing and able to take?

The return objective looks at the average yearly return needed to meet client goals in alignment with their risk tolerance. Questions during the client interview phase should reveal whether the preference is for maximizing return or minimizing losses. The risk objective measures the client’s readiness to tolerate investment risk to achieve their return objectives.

Inflation Protection: Ensuring future purchasing power is a significant concern, particularly for retired clients needing steady cash flow.

Risk Categories in Asset Classes

Different asset classes embody distinct risk levels:

Cash and Cash Equivalents

• Government Issues (less than a year): Lowest risk, highest quality
• Corporate Issues (less than a year): Higher risk, lower quality

Fixed-Income Securities

• Short-term (1–5 years): Low risk, low volatility
• Medium-term (5–10 years): Medium risk, medium volatility
• Long-term (10+ years): High risk, high volatility

Equities

• Conservative: Low risk, high capitalization, predictable earnings
• Growth: Medium risk, potential for above-average earnings growth
• Venture: High risk, low capitalization, limited earnings record
• Speculative: Maximum risk, high price volatility

Investment Components Descriptions

1. Safety of Principal: Ensuring the initial investment stays intact, accepting lower income return and growth.
2. Income: Regular cash flows from debt and equity securities, crucial for clients relying on steady income.
3. Growth: Profit made by selling securities more than their purchase cost with favorable tax considerations.

Application Examples

• Safety: Young couple saving for a house purchase.
• Income: Single parent relying on investments for additional income.
• Growth: Young executive aiming to build capital for early retirement.

Major Security Types Evaluation (Table 16.2)

Typically, clients might have secondary objectives such as liquidity and tax minimization, both of which significantly impact portfolio strategies.

Frequently Asked Questions (FAQs)

1. Why is specifying investment objectives so important? Specifying objectives allows for tailor-made investment strategies to meet unique client goals while considering their constraints and risk tolerance.

2. Can investment objectives change over time? Yes, as a client’s financial situation and life circumstances evolve, their investment objectives might require adjustments.

3. What is the relationship between risk and return? Generally, higher potential returns come with higher levels of risk, necessitating a careful balance based on client profiles.

Key Takeaways

• Investment objectives and constraints must be clearly understood to craft a reliable investment portfolio.
• Risk and return objectives are created based on in-depth client interviews and assessments.
• Awareness of various constraints, including time horizon, liquidity requirements, tax, legal, and unique individual circumstances, is essential for portfolio success.

Glossary

• Asset Allocation: Distribution of investments across various asset classes.
• Risk Tolerance: Maximum amount of variation in investment returns that a client is willing to withstand.
• Smooth Yield Curve: Representation of bond yields at different maturities, which becomes important for portfolio strategy during market fluctuations.

Equation for Expected Portfolio Return

The expected return of a portfolio can be estimated as:

• \( E(R_P) \): Expected return of the portfolio.
• \( w_i \): Weight of asset \( i \).
• \( R_i \): Return of asset \( i \).
• \( \sum_{i=1}^{n} \): Summation from 1 to \( n \) (number of assets).

Note: The weights in the portfolio must sum to 1.