Basics of Portfolio Planning | CFA Level I Portfolio Management

Welcome back as we learn the basics of portfolio planning and construction. Let’s start with the first stage: portfolio planning.

Portfolio Planning

Recall from a previous lesson, the three main stages of the portfolio management process: planning, execution or construction, and feedback or maintenance. In this lesson, we’ll dive deeper into the planning stage.

The planning stage begins with an analysis of your client’s risk tolerance, return objectives, time horizon, tax exposure, liquidity needs, legal and regulatory constraints, and any unique circumstances or preferences. Use this acronym “RRTTLLU” to help you remember these seven key elements of analyzing the client. Let’s discuss more about each item.

Risk Tolerance

Your client’s overall risk tolerance is a function of their ability to bear risk and their willingness to bear risk.

Ability to bear risk depends on their financial circumstances. Investment horizon, level of wealth relative to liabilities, job security, and insurance coverage are all factors that determine their ability to bear risk.

Willingness to bear risk is based primarily on their attitudes and beliefs about investments. These are often assessed through questionnaires or interviews, but responses can sometimes be subjective.

The general rule is to conform to the lower of your client’s ability or willingness to bear risk. Constructing a portfolio with a level of risk that your client is uncomfortable with can lead to misunderstandings if the portfolio performs poorly in the short term.

Return Objectives

The return objectives can be stated in a number of ways, such as absolute return objectives, relative return objectives, and risk objectives.

Ensure the stated risk and return objectives are compatible and realistic. Moderate expectations and help the client find an appropriate balance.

Investment Constraints

Investment constraints play an important role in the planning process. They include the investor’s time horizon, tax considerations, liquidity needs, legal and regulatory constraints, and unique needs and preferences.

Time Horizon

The time horizon refers to the amount of time until the investor needs to withdraw their investment. Generally, the longer the time horizon, the more risk the investor can afford to take in their portfolio. A long-term investor can afford to place a significant portion of their investment in risky assets, while a short-term investor should focus on low-risk assets such as short-term bonds and government securities.

Tax Considerations

Tax implications should be analyzed based on the investor’s tax bracket. Investors in higher tax brackets may prefer tax-free bonds, equities that produce capital gains, or investments with favorable tax treatment. In contrast, tax-exempt investors like pension funds often pay little or no tax, so the choice of securities often does not take tax implications into account.

Liquidity Needs

Liquidity refers to the ability to turn investment assets into cash quickly without significant price concessions. Different investors have different levels of liquidity needs. Banks and insurance companies, for example, have high liquidity needs to meet unexpected increases in withdrawals or insurance claims. In contrast, defined benefit pension plans and endowment funds typically have low liquidity needs. The assessment of the client’s liquidity needs will highly influence the type of securities deemed suitable for their portfolio.

Legal and Regulatory Constraints

Investors must comply with applicable laws and regulations. Some constraints are general financial regulations that apply to all market participants, while others are more specific to certain types of investors. The constraints can include restrictions on investing in particular types of securities and assets, or limitations on percentage allocations to specific types of investments. Corporate officers and directors are often barred from insider trading or trading in the securities of their firms or related firms.

Unique Needs and Preferences

Some clients, be it individuals or institutions, may have specific preferences or restrictions on which securities and assets may be purchased for their portfolio. These constraints are not legally required but are based on the client’s values and preferences. Examples include ethical preferences, religious beliefs, or diversification needs. Investors may want to avoid certain industries, companies with a record of human rights abuses, or investments that conflict with their religious beliefs.

After gathering and analyzing this information, document your findings in an investment policy statement (IPS). The IPS should specify a benchmark, be reviewed and updated periodically, and any time the investor’s objectives or constraints change significantly.

That concludes our discussion on the planning stage of the portfolio planning and construction process. We’ll proceed to the construction stage in the next lesson.