When asked about their investment goal, people often say, “to make a lot of money,” or some similar response.
Such a goal has 2 drawbacks:
First, it may not be appropriate for the investor.
Second, it is too open-ended to provide guidance for specific investments and time frames.
Such an objective is well suited for someone going to the racetrack or buying lottery tickets, but it is inappropriate for someone investing funds in financial and real assets for the long term.
An important purpose of well define investment plan is to help investors understand their own needs, objectives and investment constraints. As part of this, investors need to learn about financial markets and the risks of investing. This background will help prevent them from making inappropriate investment decisions in the future and will increase the possibility that they will satisfy their specific, measurable financial goals.
Thus, a well define investment plan helps the investor to specify realistic goals and become more informed about the risks and costs of investing.
Market values of assets, weather they be stocks, bonds, or real estate, can fluctuate dramatically. A review of market history shows that it is not unusual for asset prices to decline by 10 percent to 20 percent over several months. Investor will typically focus on a single statistic, such as a 10% average annual compounded rate of return on stocks, and expect the market risk of 10% every year. Such thinking ignores the risk of stock investing. Part of the process of developing a well define investment plan is for the investor to become familiar with the risks of investing, because we know that a strong positive relationship exists between risk and return.
In summary, constructing a well define investment plan is mainly the investor’s responsibility. It is a process whereby investors articulate their realistic needs and goals and become familiar with financial markets and investing risks. The results of bypassing this step will most likely be future aggravation, dissatisfaction and disappointment.
To construct a well define investment plan, an investor need to look into investment objectives and constraints.
Investment Objectives
The investor objectives are his or her investment goals expressed in term of both risk and returns. The relationship between risk and returns requires that goals not be expressed only in term of returns. Expressing goals only in terms of returns can lead to inappropriate investment practices, such as the use of high-risk investment strategies , which might not be suitable for the investor.
For example, a person may have a stated return goal such as “double my investment in 5 years.” Before such a statement becomes part of the well define investment plan, the investor must become fully informed of investment risks associated with such goal, including the possible of loss. A careful analysis of risk tolerance should precede any discussion of return objectives. It makes little sense for a person who is risk averse to invest funds in high risk assets.
Sometimes investment magazines or books contain tests that individual can take to help them evaluate their risk tolerance. Subsequently, investor can use the results of this evaluation to categorize risk tolerance and develop an initial asset allocation.
Risk tolerance is more than a function of an individual’s psychological makeup; it is affected by other factors, including a person’s current insurance coverage and cash reserves.
Risk tolerance is also affected by an individual’s family situation (for example : Marital status and the number and ages of children) and by his or her age. We know that older persons generally have shorter investment time frames within which to make up any losses; they also have years of experience, including living through various gyrations and “corrections”( a euphemism for downtrend or crashes) that younger people have not experienced or whose effect they do not fully appreciate.
Risk tolerance is also influenced by one’s current net worth and income expectations. All else being equal, individuals with higher incomes have a greater propensity to undertake risk because their incomes can help cover any shortfall. Likewise, individuals with larger net worth can afford to place some assets in risky investments while the remaining assets provide a cushion against losses.
A person’s return objective may be stated in terms of an absolute or a relative percentage return, but it may also be stated in term of general goal, such as capital preservation, current income, capital appreciation or total return.
Investment Objective: 25 years old investor versus 55 years old investor
What is an appropriate investment objective for a typical 25-years-old investor?
Assume he holds a steady job, is a valued employee, has adequate insurance coverage, and has enough money in the bank to provide a cash reserve. Let’s also assume that his current long term, high-priority investment goal is to build a retirement fund.
Departing on his risk preferences, he can select a strategy carrying moderate to high amounts of risks because the income stream from his job will probably grow over time. Further, given his young age and income growth potential, a low-risk strategy, such as capital preservation or current income, is inappropriate for his retirement fund goal; a total return or capital appreciation objectives would be most appropriate. Here’s a possible objective statement.
Invest funds in a variety of moderate-to higher risk investments. The average risk of the equity portfolio should exceed that of a board stock market index. Domestic equity exposure should range from 80 percent to 95 percent of the total portfolio. Remaining funds should be invested in short and intermediate term notes and bonds.
Assume a typical 55-years-old investor like-wise has adequate insurance coverage and a cash reserve. Let’s also assume she is retiring this year.
This individual will want less risk exposure than the 25-years-old investor, because her earning power from employment will soon be ending; she will not be able to recover any investment losses by saving more out of her paycheck. Depending on her income from pension plan, she may need some current income from her retirement portfolio to meet living expenses. Given that she can expect to live an average of another 20 - 30 years, she will need protection against inflation. A risk-averse investor will choose a combination of current income and total return in an attempt to have principal growth outpace inflation.
Here’s an example of such an objective statement:
Invest in stock, bond and certificate of deposit investments to meet income needs (from bond income, interest income and stock dividends) and to provide for real growth (from equities). Fixed income securities should comprise 55 – 65 percent of the total portfolio; of this, 5 – 15 percent should be invested in short term securities for extra liquidity and safety. The remaining 35 – 45 percent of portfolio should be invested in high-quality stock whose risk is similar to equity index.
More detailed analyses for 25-year-old and 55-year-old investor would make more specific assumptions about the risk tolerance of each, as well as clearly enumerate their investment goals, return objectives, the funds they have to invest at the present, the funds they expect to invest over time, and the benchmark portfolio that will be used to evaluate performance.
Investment Constraints
In addition to the investment objectives that set limits on risk and return, certain other constraints also affect the investment plan. Investment constraints include liquidity needs, investment time horizon, tax factors, legal and regulatory constraints, and unique needs and preferences.
Liquidity needs
An asset is liquid if it can be quickly converted to cash at a price close to fair market value. Generally, asset are more liquid if many traders are interested in a fairly standardize product. In general, stocks and short term certificate of deposit are a highly liquid security; real estate and venture capital are not.
Investors may have liquidity needs that the investment plan must consider. For example, although an investor may have a primary long term goal, several near-term goals may require available funds. Wealthy individuals with sizeable tax obligations need adequate liquidity to pay their taxes without upsetting their investment plan. Some retirement plans may need funds for shorter-term purposes, such as buying a car or a house or making college tuition payments.
An investor at young age probably has little need for liquidity as he focuses on his long term retirement funds goal. This constraint may change, however, should he face a period of unemployment or should near-term goals, such as honeymoon expenses or a house down payment, enter the picture.
An investor at older age has a greater need for liquidity. Although she may receive regular income from pension plan, it is not likely that they will equal to work paycheck. She will want some of her portfolio in liquid securities to meet unexpected expenses or bills.
Time Horizon
Time horizon as an investment constraint briefly entered our earlier discussion of near-term and long term high priority goals. A close (but not perfect) relationship exists between an investor’s time horizon, liquidity needs, and ability to handle risk.
Investor with long investment horizons generally require less liquidity and can tolerate greater portfolio risk; less liquidity because the funds are not usually needed for many years; greater risk tolerance because any shortfalls or losses can be overcome by returns earned in subsequence years.
Investors with shorter time horizons generally favor more liquid and less risky investments because losses are harder to overcome during a shorter time frame.
Because of life expectancies, a young age investor has a longer investment time horizon than an older age investor. Thus, a young age investor will have a greater proportion of his portfolio in equities – including stocks in small firms than older age investor.
Tax concern
Investment planning is complicated by the tax code; Taxable income from interest, dividends and rents is taxable at the investor’s marginal tax rate. The marginal tax rate is the proportion of the next one dollar in income paid as taxes. Capital gain or losses arise from asset price changes. Either capital gain tax is imposed, is depends on different country tax jurisdiction. They are tax differently than income. Income is taxed when it is received; capital gains or losses are taxed only when an asset is sold and the gain or loss, relative to it initial cost, is realized. Unrealized capital gains or losses reflect the price change in currently held assets that have not been sold; the tax liability on unrealized gains can be deferred indefinitely.
Simple formula below illustrates future value of investment with taxes on dividend / interest income versus capital gains.
Estimated future value of investment for dividend/interest ( tax paid annually)
Future value = INV x [ 1 + r (1- T ) ]N
INV = amount invested today
r = expected rate of return
T = tax rate on dividend
N = time horizon of investment
Estimated future value of investment for capital gain ( tax paid when gain is realized)
Future value = INV x ( 1 + r )N x (1- T )
INV = amount invested today
r = expected rate of return
T = tax rate on capital gain
N = time horizon of investment
For a married person , jointly or separate income tax filling will also affect marginal tax rate on taxable income.
Legal and regulatory Factors
Both the investment process and the financial markets are highly regulated and subject to numerous laws. At times , these legal and regulatory factors constrain the investment strategy of individuals and institutions.
Investors are advice to understand the legal and regulatory factors imposed on the choice of investment.
Unique Needs and Preferences
This category covers the individual and sometimes idiosyncratic concerns of each investor. Some investors may want to exclude certain investments from their portfolio solely on the basis of personal preference or for social consciousness reasons . For example , they may request that no firms that manufacture or sell tobacco , alcohol , pornography , or environmental harmful products be included in their portfolio. Some mutual funds screen according to this type of social responsibility criterion.
Another example of personal constraint is the time and expertise a person has for managing his or her portfolio. Busy executives may prefer to relax during nonworking hours and let a trusted advisor manage their investments. Retirees , on the other hand , may have the time but believe they lack of expertise to choose and monitor investments, so they also may seek professional advice.
