CHAPTER 4

INVESTORS AND THE INVESTMENT PROCESS

AFTER STUDYING THIS CHAPTER YOU
SHOULD BE ABLE TO:

• Specify investment objectives of individual and institutional investors.

• Identify constraints on individual and institutional investors.
• Compare and contrast major types of investment policies.
Introduction
Translating diverse households' aspirations and circumstances into
appropriate investment decisions is a challenging task for institutions,
which often have multiple stakeholders and are regulated by authorities.
The investment process is not easily reduced to a simple algorithm, as
each investor's circumstances are unique due to factors such as tax
bracket, age, risk tolerance, wealth, and job prospects. This chapter
focuses on the systematic review of investors' objectives, constraints, and
circumstances, examining the major classes of institutional investors and
the special issues they must confront. The Association for Investment
Management and Research (AIMR) suggests a high-quality systematic
approach, which is also endorsed by a respected professional group
through its curriculum. This approach is a useful case study for
understanding the best investment process for different investors.
The basic framework involves dividing the
investment process into four stages:

1. specifying objectives,
2. specifying constraints,
3. formulating policy, and
4. monitoring and updating the portfolio as needed.
INVESTORS
The investment process involves determining the risk-return tradeoff
between the desired rate of return and the risk to which the investor is
exposed. While everyone desires high return and low risk, competition in
security markets ensures that high expected return comes with high
risk. The desired tradeoff depends on the investor's attitude and ability
to bear risk, which is influenced by factors like age, wealth, and other
circumstances. Professional investors managing portfolios must gauge
the appropriate risk profile of their clients. The investment process
involves surveying the issues and objectives that influence the decisions
of individual and institutional investors, who either invest on their own
account or require investment managers.
INDIVIDUAL INVESTORS
The factors affecting an individual investor typically stem from their life
cycle stage. Education is the first significant investment decision,
focusing on human capital. During early working years, earning power
from skills is the primary asset, and insurance against disability or
death is crucial. Owning a house is another significant economic asset,
serving as a hedge against rental rate increases and potential
availability issues.
As one ages and accumulates savings for consumption during retirement,
wealth composition shifts from human capital to financial capital.
Portfolio choices become more important, and in middle age, investors
are willing to take on significant portfolio risk to increase expected
returns. However, as retirement approaches, risk tolerance diminishes.

The life-cycle view of investment behavior supports this view, with

attitudes shifting away from risk tolerance and toward risk aversion as
investors near retirement age. As individuals lose the potential to
recover from disastrous investment performance, they shift to safe
assets. Life-cycle financial planning is a challenging task, leading to the
emergence of an industry providing personal financial advice.
TABLE 4.1
AMOUNT OF RISK INVESTORS SAID THEY
WERE WILLING TO TAKE BY AGE

Under 35 35-54 35-54

No risk 54% 57% 71%
A little risk 30 30 21
Some risk 14 18 8
A lot of risk 2 1 1
PROFESSIONAL INVESTORS

Professional investors provide investment management services for a fee.

Some are employed directly by wealthy individual investors. Most
professional investors, however, either pool many individual investor
funds and manage them or serve institutional investors.
PERSONAL TRUSTS
A personal trust is a legal agreement where an individual grants
property to a trustee, typically a bank, lawyer, or investment
professional, who manages it for beneficiaries. The trustee's role is to
manage the property, and the investment is subject to state trust laws
and prudent man rules. Trusts typically have broader objectives than
individual investors, and their managers are expected to invest with
more risk aversion due to their fiduciary responsibility. Certain asset
classes and strategies, such as short-selling or buying on margin, are
excluded from trust investments.
MUTUAL FUNDS
Mutual funds are firms that manage pools of individual investor money.
They invest in various specified ways and issue shares that entitle
investors to a pro rata portion of the income generated by the funds. A
mutual fund's objectives are spelled out in its prospectus. We discussed
mutual funds in detail in Chapter 3.
PENSION FUNDS
There are two basic types of pension plans:
1. defined contribution and
2. defined benefit.
Defined contribution plans are in effect savings accounts established by the firm for its
employees. The employer contributes funds to the plan, but the employee bears all the
risk of the fund's investment performance. These plans are called defined contribution
because the firm's only obligation is to make the stipulated contributions to the
employee's retirement account. The employee is responsible for directing the
management of the assets, usually by selecting among several investment funds in
which the assets can be placed. Investment earnings in these retirement plans are not
taxed until the funds are withdrawn, usually after retirement.
In defined benefit plans, the employer is obligated to provide a specified
annual retirement benefit, which is determined by a formula that takes
into account years of service and salary levels. The assets in the pension
fund provide collateral for the promised benefits, and if the investment
performance of the assets is poor, the firm is obligated to make up the
shortfall by contributing additional assets to the fund. In contrast to
defined contribution plans, the risk surrounding investment performance
in defined benefit plans is borne by the firm. A pension actuary makes an
assumption about the rate of return on the plan's assets and uses this to
compute the amount the firm must contribute regularly to fund the
plan's liabilities. If the actual rate of return exceeds the actuarial
assumed rate, the firm's shareholders may receive an unanticipated
gain, while if the plan's actual rate of return falls short, the firm must
increase future contributions. The main objective of a defined benefit
pension plan is to reward shareholders for bearing this risk. Many
pension plans view their assumed actuarial rate of return as their target
rate of return and have little tolerance for earning less than that.
LIFE INSURANCE COMPANIES
Life insurance companies generally invest so as to hedge their liabilities,
which are defined by the policies they write. The company can reduce its
risk by investing in assets that will return more in the event the
insurance policy coverage becomes more expensive.
For example, if the company writes a policy that pays a death benefit
linked to the consumer price index, then the company is subject to
inflation risk. It would search for assets expected to return more when
the rate of inflation rises, thus hedging the price index linkage of the
policy.
There are as many objectives as there are distinct
types of insurance policies. Until the 1970s, only
two types of life insurance policies were available
for individuals:

• whole life and

• term.
A whole life insurance policy combines a death benefit with a kind of
savings plan that provides for a gradual buildup of cash value that the
policyholder can withdraw later in life, usually at age 65.

Term insurance, on the other hand, provides death benefits without cash
value buildup. Whole-life policies have a fixed interest rate, which can be
hedged by investing in long-term bonds. Insurance companies have seen
changes in policyholder behavior in recent decades. During high-interest-
rate years of the 1970s and early 1980s, older whole-life policies allowed
borrowing rates as low as 4 or 5% per year. Some holders borrowed
heavily against the cash value to invest in assets with double-digit
yields. Some policyholders abandoned whole life policies and took out
term insurance, accounting for over half the volume of new sales of
individual life policies.
In response to these developments, the insurance
industry came up with two new policy types:
• variable life and
• universal life.

Variable and universal life insurance policies offer fixed death benefits and cash value
that can be invested in mutual funds. Variable policies allow policyholders to adjust the
insurance premium or death benefit based on their needs, while universal policies allow
for increased or reduced premiums. The cash value component's interest rate changes
with market interest rates. These policies are tax-advantaged, as earnings are not
taxed until withdrawal. Life insurance companies can be organized as mutual or stock
companies, with mutual companies focusing on policyholder benefit, and stock
companies aiming to maximize shareholder value. The organizational form affects the
company's investment objectives.
NONLIFE INSURANCE COMPANIES
Nonlife insurance companies, like property and casualty insurers, have
investable funds as they pay claims after collecting policy premiums.
Typically, they are conservative in their attitude toward risk. As with life
insurers, nonlife insurance companies can be either stock companies or
mutual companies. Pension plans and insurance companies aim to hedge
predictable long-term liabilities using bonds of various maturities, as
part of investment strategies.
BANKS
Bank investments are loans to businesses and consumers, with most liabilities being
accounts of depositors. Banks aim to match asset risk to liabilities while earning a
profitable spread between lending and borrowing rates. The bank interest rate spread
is the difference between the interest charged to a borrower and the interest rate that
banks pay on their liabilities. Most bank liabilities are checking accounts, time or
saving deposits, and certificates of deposit (CDs), with checking account funds having
the shortest maturity. Time or saving deposits have various maturities, with the
average being about one year. CDs are bonds issued by banks to investors with varying
maturities. Traditionally, a significant part of the banking industry's loan portfolio has
been in collateralized real estate loans, known as mortgages, which are typically 15 to
30 years longer than the average liability. This exposure to interest rate risk has
contributed to the S&L debacle of the 1980s, as banks were more willing to assume
greater risk to achieve higher returns. Deposits are insured by the Federal Deposit
Insurance Corporation (FDIC) or the now-defunct Federal Savings and Loans
Insurance Corporation (FSLIC).
ENDOWMENT FUNDS
Endowment funds are nonprofit organizations that use their funds for
specific purposes, typically managed by educational, cultural, or
charitable organizations or independent foundations. They are financed
by gifts from sponsors and aim to produce a steady income flow with
moderate risk. Trustees can specify additional objectives as
circumstances require.
INVESTOR CONSTRAINTS
Different households and institutions may choose different investment
portfolios due to their different circumstances, such as tax status,
liquidity requirements, or regulatory restrictions. These constraints
determine the appropriate investment policy. Constraints usually relate
to investor circumstances, such as high liquidity demand for college
tuition. External constraints, such as legal limitations on assets held by
banks and trusts, can also impact portfolio choices. Some constraints are
self-imposed, such as "social investing," which prohibits holding shares of
firms involved in ethically objectionable activities.
Five common types of constraints:
1. LIQUIDITY
Liquidity refers to the speed and ease with which an asset can be sold at
a fair price, influenced by the time dimension and price dimension of the
investment asset. It is measured by the discount from the fair market
price. Cash and money market instruments like Treasury bills and
commercial paper are the most liquid assets, while real estate is the
least. Office buildings and manufacturing structures can suffer a 50%
liquidity discount. Individual and institutional investors must determine
their likelihood of short-term cash needs to establish the minimum level
of liquid assets in their investment portfolio.
Five common types of constraints:
2. INVESTMENT HORIZON
An investment horizon is the planned liquidation date of an investment,
such as the time to fund a college education or a university endowment's
major campus construction project. It is crucial for investors to consider
when choosing between assets of different maturities, as the maturity
date of a bond may make it more attractive if it coincides with a cash
need date.
Five common types of constraints:
3. REGULATIONS
Professional and institutional investors are subject to regulations,
including prudent man law, which requires them to restrict investment
to assets approved by a prudent investor. This law is nonspecific and
requires investors to defend their investment policies in court, with
interpretation varying based on current standards. Institutional
investors also face specific regulations, such as U.S. mutual funds being
limited to 5% of publicly traded corporation shares.
Five common types of constraints:
4. TAX CONSIDERATIONS
Tax consequences are central to investment decisions. The performance
of any investment strategy should be measured by its rate of return after
taxes. For household and institutional investors who face significant tax
rates, tax sheltering and deferral of tax obligations may be pivotal in
their investment strategy.
Five common types of constraints:
5. UNIQUE NEEDS
Investors face unique circumstances, such as high-paying jobs in a cyclical industry or
the risk of a deterioration in the aerospace industry. These individuals need to hedge
the risk of a deterioration in the industry's economic well-being. On the other hand,
executives on Wall Street who own an apartment near work are doubly exposed to the
vagaries of the stock market. The purchase of a diversified stock portfolio would
increase the exposure to the stock market. The job is often the primary investment of
an individual, and the unique risk profile from employment can significantly influence
a suitable investment portfolio. Other unique needs of individuals include retirement,
housing, and children's education, which affect investment policy. Institutional
investors also face unique needs, such as pension funds varying in their investment
policy based on the average age of plan participants or a university requiring cash
income from the endowment fund, resulting in a preference for high-dividend-paying
assets.
Table 4.2 DETERMINATION OF PORFOLIO
POLICIES. Summarizes the types of objectives and constraints that investors
must face as they form their investment portfolios.

Objectives Constraints
Return Requirements Liquidity
Risk tolerance Horizon
Regulations
Taxes
Unique needs. Examples:
• Ethical concerns
• Specific hedging needs
• Age
• Wealth
TABLE 4.3 MATRIX OF OBJECTIVES
TYPE OF INVESTOR RETURN REQUIREMENT RISK TOLERANCE
Individual and personal trusts Life cycle(education, children, Life cycle (younger are more
retirement) risk tolerant)
Mutual funds Variable Variable
Pension funds Assumed actuarial rate Depends on proximity of
payouts
Endowment funds Determined by current income Generally conservative
needs and need for asset
growth to maintain real value

Life insurance companies Should exceed new money rate Conservative

by sufficient margin to meet
expenses and profit objectives;
also actuarial rates important
Nonlife insurance companies No minimum Conservative
Banks Interest spread Variable
OBJECTIVES AND CONSTRAINTS OF VARIOUS
INVESTORS
Table 4.3 presents a matrix of objectives for investors, focusing on mutual funds,
pension funds, and life insurance companies. Mutual funds have variable return
requirements and risk tolerances, catering to different investor groups. High-income
funds cater to conservative investors, while high growth funds cater to risk-tolerant
ones. Tax-free bond funds segment the market by tax obligation. Pension funds must
meet the actuarial rate, which establishes the fund return requirement and low
additional risk tolerance. Life insurance companies have obligations to whole-life
policyholders similar to pension funds, requiring them to earn a minimum rate to meet
liabilities. Banks earn profit from the interest rate spread between loans and deposits
and CDs, as well as fees for services. Balancing the loan portfolio with deposits and CDs
is crucial for managing bank assets. Banks can increase interest rate spread by lending
to riskier borrowers and increasing the proportion of longer-term loans. However, these
policies must match the risk tolerance of shareholders and bank capital regulations are
risk-based, requiring higher capital requirements and potential regulatory interference.
TABLE 4.4 MATRIX OF CONSTRAINTS
TYPE OF LIQUIDITY HORIZON REGULATORY TAXES
INVESTOR
Individual and Variable Life cycle Prudent, man Variable
personal trusts laws (for trust)
Mutual funds Low Short Little None
Pension funds Young,low; Long ERISA None
mature, high
Endowment Little Long Little None
funds
Life insurance Low Long Complex Yes
companies
Nonlife insurance High Short Little Yes
companies
Banks Low Short Changing Yes
OBJECTIVES AND CONSTRAINTS OF VARIOUS
INVESTORS
Table 4.4 presents a matrix of constraints for various investors. As you would expect
liquidity and tax constraints for individuals are variable because of wealth and age
differentials. A particular constraint for mutual funds arises due to investor response to
fund performance, with unsatisfactory returns leading to redemption and contracting.
Conversely, high returns can lead to popularity and asset growth. Pension funds are
heavily regulated by the Employee Retirement Security Act of 1974 (ERISA), which
requires mature funds to pay out more than younger ones, requiring more liquidity.
Endowment funds typically do not need to liquidate assets or use dividend income to
finance payouts, as contributions are expected to exceed payouts and increase the
fund's real value. Life insurance companies face complex regulation, with the corporate
tax rate being a significant concern. Property and casualty insurance, written on a
short-term basis, must be renewed annually, resulting in short-term horizon
constraints. Banks face short horizon constraints due to the interest rate risk
component of the interest rate spread, which involves financing long-term assets with
short-term liabilities.