Chapter 12 (Personal Finance) Notes

Investing INTRODUCTION Saving to build wealth is investing. When people have too much money to spend immediately, that is, a surplus of disposable income, they become savers or investors. They transfer their surplus to individuals, companies, or governments that have a shortage or too little money to meet immediate needs. This is almost always done through an intermediary—a bank or broker—who can match up the surpluses and the shortages. If the capital markets work well, those who need money can get it, and those who can defer their need can try to profit from that. When you invest, you are transferring capital to those who need it on the assumption that they will be able to return your capital when you need or want it and that they will also pay you for its use in the meantime. Investing happens over your lifetime. In your early adult years, you typically have little surplus to invest. Your first investments are in your home (although primarily financed with the debt of your mortgage) and then perhaps in planning for children’s education or for your retirement. After a period of just paying the bills, making the mortgage, and trying to put something away for retirement, you may have the chance to accumulate wealth. Your income increases as your career progresses. You have fewer dependents (as children leave home), so your expenses decrease. You begin to think about your investment options. You have already been investing—in your home and retirement—but those investments have been prescribed by their specific goals. You may reach this stage earlier or later in your life, but at some point, you begin to think beyond your immediate situation and look to increase your real wealth and to your future financial health. Investing is about that future. 1. INVESTMENTS AND MARKETS: A BRIEF OVERVIEW L E A R N I N G O B J E C T I V E S 1. 2. 3. 4. Identify the features and uses of issuing, owning, and trading bonds. Identify the uses of issuing, owning, and trading stocks. Identify the features and uses of issuing, owning, and trading commodities and derivatives. Identify the features and uses of issuing, owning, and trading mutual funds, including exchange-traded funds and index funds. 5. Describe the reasons for different instruments in different markets. Before looking at investment planning and strategy, it is important to take a closer look at the galaxy of investments and markets where investing takes place. Understanding how markets work, how different investments work, and how different investors can use investments is critical to understanding how to begin to plan your investment goals and strategies. You have looked at using the money markets to save surplus cash for the short term. Investing is primarily about using the capital markets to invest surplus cash for the longer term. As in the money markets, when you invest in the capital markets, you are selling liquidity. The capital markets developed as a way for buyers to buy liquidity. In Western Europe, where many of our ideas of modern finance began, those early buyers were usually monarchs or members of the nobility, raising capital to finance armies and navies to conquer or defend territories or resources. Many devices and markets were used to raise capital,[1] but the two primary methods that have evolved into modern times are the bond and stock markets. (Both are discussed in greater detail in Chapter 15 and Chapter 16, but a brief introduction is provided here to give you the basic idea of what they are and how they can be used as investments.) In the United States, 47 percent of the adult population owns stocks or bonds, most through retirement accounts.[2] F I G U RE 12.2 Amsterdam Stock Exchange The Amsterdam Stock Exchange was established in 1602 by the Dutch East India Company, the first company in the world to issue stock and trade publicly. The company paid 18 percent annually for nearly two hundred years, based on its near monopoly of the Indonesian spice trade. Competition and corruption ended the exchange, which went bankrupt in 1798. © Amsterdam Municipal Department for the Preservation and Restoration of Historic Buildings and Sites; used by permission. 1.1 Bonds and Bond Markets bonds Publicly issued and traded long-term debt used by corporations and governments. fixed interest rate A bond interest rate that does not change over time, from issuance to maturity. floating interest rate A bond interest rate that changes over time, usually related to a benchmark rate such as the U.S. discount rate or prime rate. Bonds are debt. The bond issuer borrows by selling a bond, promising the buyer regular interest pay- ments and then repayment of the principal at maturity. If a company wants to borrow, it could just go to one lender and borrow. But if the company wants to borrow a lot, it may be difficult to find any one investor with the capital and the inclination to make large a loan, taking a large risk on only one borrower. In this case the company may need to find a lot of lenders who will each lend a little money, and this is done through selling bonds. A bond is a formal contract to repay borrowed money with interest (often referred to as the coupon) at fixed intervals. Corporations and governments (e.g., federal, state, municipal, and foreign) borrow by issuing bonds. The interest rate on the bond may be a fixed interest rate or a floating interest rate that changes as underlying interest rates—rates on debt of comparable companies—change. (Underlying interest rates include the prime rate that banks charge their most trustworthy borrowers and the target rates set by the Federal Reserve Bank.) There are many features of bonds other than the principal and interest, such as the issue price (the price you pay to buy the bond when it is first issued) and the maturity date (when the issuer of the bond has to repay you). Bonds may also be “callable”: redeemable before maturity (paid off early). Bonds may also be issued with various covenants or conditions that the borrower must meet to protect the bondholders, the lenders. For example, the borrower, the bond issuer, may be required to keep a certain level of cash on hand, relative to its short-term debts, or may not be allowed to issue more debt until this bond is paid off. Because of the diversity and flexibility of bond features, the bond markets are not as transparent as the stock markets; that is, the relationship between the bond and its price is harder to determine. The U.S. bond market is now more than twice the size (in dollars of capitalization) of all the U.S. stock exchanges combined, with debt of more than $27 trillion by the end of 2007.[3] U.S. Treasury bonds are auctioned regularly to banks and large institutional investors by the Treasury Department, but individuals can buy U.S. Treasury bonds directly from the U.S. government (http://www.treasurydirect.gov). To trade any other kind of bond, you have to go through a broker. The brokerage firm acts as a principal or dealer, buying from or selling to investors, or as an agent for another buyer or seller. 1.2 Stocks and Stock Markets Stocks or equity securities are shares of ownership. When you buy a share of stock, you buy a share of the corporation. The size of your share of the corporation is proportional to the size of your stock holding. Since corporations exist to create profit for the owners, when you buy a share of the corporation, you buy a share of its future profits. You are literally sharing in the fortunes of the company. Unlike bonds, however, shares do not promise you any returns at all. If the company does create a profit, some of that profit may be paid out to owners as a dividend, usually in cash but sometimes in additional shares of stock. The company may pay no dividend at all, however, in which case the value of your shares should rise as the company’s profits rise. But even if the company is profitable, the value of its shares may not rise, for a variety of reasons having to do more with the markets or the larger economy than with the company itself. Likewise, when you invest in stocks, you share the company’s losses, which may decrease the value of your shares. Corporations issue shares to raise capital. When shares are issued and traded in a public market such as a stock exchange, the corporation is “publicly traded.” There are many stock exchanges in the United States and around the world. The two best known in the United States are the New York Stock Exchange (now NYSE Euronext), founded in 1792, and the NASDAQ, a computerized trading system managed by the National Association of Securities Dealers (the “AQ” stands for “Automated Quotations”). Only members of an exchange may trade on the exchange, so to buy or sell stocks you must go through a broker who is a member of the exchange. Brokers also manage your account and offer varying levels of advice and access to research. Most brokers have Web-based trading systems. Some discount brokers offer minimal advice and research along with minimal trading commissions and fees. issue price The original market price of a bond at issuance. maturity date Date at which a bond matures, or the end of the bond’s term, when the bond must be redeemed. redeemable A bond that is eligible for redemption. maturity The date on which payment of a financial obligation is due, such as bond redemption date. bond covenant A condition placed on bond issuers (borrowers) to protect bondholders (lenders). stock Shares issued to account for ownership, as defined by owners’ contributions to a corporation. dividend A share of corporate profit distributed to shareholders, usually as cash or corporate stock. stock exchange An organized market for the trading of corporate shares conducted by members of the exchange. F I G U RE 12. 3 Shanghai Stock Exchange, China The Shanghai Stock Exchange (SSE), one of three exchanges in China, is not open to foreign investors. It is the sixth largest stock exchange in the world. The other exchanges in China are the Shenzhen Stock Exchange (SZSE) and the Hong Kong Stock Exchange (HKE). The Hang Seng is an index of Asian stocks on the HKE that is popular with investors interested in investing in Asian companies. © Baycrest Gallery, used by permission 1.3 Commodities and Derivatives commodities Raw materials—natural resources or agricultural products—used as inputs in processing goods and services. futures A publicly traded contract to buy or sell an asset at a specified time and price in the future. forwards A private contract to buy or sell an asset at a specified time and price in the future. derivatives Financial instruments such as options, futures, forwards, securitized assets, and so on whose value is derived from the value of another asset. Commodities are resources or raw materials, including the following: Agricultural products (food and fibers), such as soybeans, pork bellies, and cotton Energy resources such as oil, coal, and natural gas < Precious metals such as gold, silver, and copper < Currencies, such as the dollar, yen, and euro < < Commodity trading was formalized because of the risks inherent in producing commodities—raising and harvesting agricultural products or natural resources—and the resulting volatility of commodity prices. As farming and food production became mechanized and required a larger investment of capital, commodity producers and users wanted a way to reduce volatility by locking in prices over the longer term. The answer was futures and forward contracts. Futures and forward contracts or forwards are a form of derivatives, the term for any financial instrument whose value is derived from the value of another security. For example, suppose it is now July 2010. If you know that you will want to have wheat in May of 2011, you could wait until May 2011 and buy the wheat at the market price, which is unknown in July 2010. Or you could buy it now, paying today’s price, and store the wheat until May 2011. Doing so would remove your future price uncertainty, but you would incur the cost of storing the wheat. Alternatively, you could buy a futures contract for May 2011 wheat in July 2010. You would be buying May 2011 wheat at a price that is now known to you (as stated in the futures contract), but you will not take delivery of the wheat until May 2011. The value of the futures contract to you is that you are removing the future price uncertainty without incurring any storage costs. In July 2010 the value of a contract to buy May 2011 wheat depends on what the price of wheat actually turns out to be in May 2011. Forward contracts are traded privately, as a direct deal made between the seller and the buyer, while futures contracts are traded publicly on an exchange such as the Chicago Mercantile Exchange (CME) or the New York Mercantile Exchange (NYMEX). When you buy a forward contract for wheat, for example, you are literally buying future wheat, wheat that doesn’t yet exist. Buying it now, you avoid any uncertainty about the price, which may change. Likewise, by writing a contract to sell future wheat, you lock in a price for your crop or a return for your investment in seed and fertilizer. Futures and forward contracts proved so successful in shielding against some risk that they are now written for many more types of “commodities,” such as interest rates and stock market indices. More kinds of derivatives have been created as well, such as options. Options are the right but not the obligation to buy or sell at a specific price at a specific time in the future. Options are commonly written on shares of stock as well as on stock indices, interest rates, and commodities. Derivatives such as forwards, futures, and options are used to hedge or protect against an existing risk or to speculate on a future price. For a number of reasons, commodities and derivatives are more risky than investing in stocks and bonds and are not the best choice for most individual investors. options The right but not the obligation to buy or sell at a specific price at a specific time in the future; commonly written on shares of stock as well as on stock indices, interest rates, and commodities. 1.4 Mutual Funds, Index Funds, and Exchange-Traded Funds A mutual fund is an investment portfolio consisting of securities that an individual investor can invest in all at once without having to buy each investment individually. The fund thus allows you to own the performance of many investments while actually buying—and paying the transaction cost for buying—only one investment. Mutual funds have become popular because they can provide diverse investments with a minimum of transaction costs. In theory, they also provide good returns through the performance of professional portfolio managers. An index fund is a mutual fund designed to mimic the performance of an index, a particular collection of stocks or bonds whose performance is tracked as an indicator of the performance of an entire class or type of security. For example, the Standard & Poor’s (S&P) 500 is an index of the five hundred largest publicly traded corporations, and the famous Dow Jones Industrial Average is an index of thirty stocks of major industrial corporations. An index fund is a mutual fund invested in the same securities as the index and so requires minimal management and should have minimal management fees or costs. Mutual funds are created and managed by mutual fund companies or by brokerages or even banks. To trade shares of a mutual fund you must have an account with the company, brokerage, or bank. Mutual funds are a large component of individual retirement accounts and of defined contribution plans. Mutual fund shares are valued at the close of trading each day and orders placed the next day are executed at that price until it closes. An exchange-traded fund (ETF) is a mutual fund that trades like a share of stock in that it is valued continuously throughout the day, and trades are executed at the market price. The ways that capital can be bought and sold is limited only by the imagination. When corporations or governments need financing, they invent ways to entice investors and promise them a return. The last thirty years has seen an explosion in financial engineering, the innovation of new financial instruments through mathematical pricing models. This explosion has coincided with the ever-expanding powers of the computer, allowing professional investors to run the millions of calculations involved in sophisticated pricing models. The Internet also gives amateurs instantaneous access to information and accounts. Much of the modern portfolio theory that spawned these innovations (i.e., the idea of using the predictability of returns to manage portfolios of investments) is based on an infinite time horizon, looking at performance over very long periods of time. This has been very valuable for institutional investors (e.g., pension funds, insurance companies, endowments, foundations, and trusts) as it gives them the chance to magnify returns over their infinite horizons. For most individual investors, however, most portfolio theory may present too much risk or just be impractical. Individual investors don’t have an infinite time hori- F I G U RE 12. 4 zon. You have only a comparatively small amount of time to create wealth and to enjoy it. For individual investors, investing is a process of balancing the demands and desires of returns with the costs of risk, before time runs out. mutual fund A portfolio of investments created by an investment company such as a brokerage or bank. It is financed as the investment company sells shares of the fund to investors. For investors, a mutual fund provides a way to achieve maximum diversification with minimal transaction costs through economies of scale. index fund A mutual fund designed to track the performance of an index for investors who seek diversification without having to select securities. exchange-traded fund (ETF) A fund that tracks an index or a commodity or a basket of assets but is traded like stocks on a stock exchange. financial engineering The use of mathematical modeling to create and value new financial instruments and markets. K E Y < < < < < < < < < < natural or cultivated resources; traded to hedge revenue or production needs or to speculate on resources’ prices; traded on commodities exchanges through brokers. Derivatives are instruments based on the future, and therefore uncertain, price of another security, such as a share of stock, a government bond, a currency, or a commodity. Mutual funds are portfolios of investments designed to achieve maximum diversification with minimal cost through economies of scale. < < < a way to raise capital through selling ownership or equity; an investment for shareholders that creates return through the distribution of corporate profits as dividends or through gains (losses) in corporate value; traded on stock exchanges through member brokers. Commodities are < < a way to raise capital through borrowing, used by corporations and governments; an investment for the bondholder that creates return through regular, fixed or floating interest payments on the debt and the repayment of principal at maturity; traded on bond exchanges through brokers. Stocks are < < T A K E A WA Y S Bonds are An index fund is a mutual fund designed to replicate the performance of an asset class or selection of investments listed on an index. An exchange-traded fund is a mutual fund whose shares are traded on an exchange. Institutional and individual investors differ in the use of different investment instruments and in using them to create appropriate portfolios. E X E R C I S E S 1. In My Notes or your personal finance journal, record your experiences with investing. What investments have you made, and how much do you have invested? What stocks, bonds, funds, or other instruments, described in this section, do you have now (or had in the past)? How were the decisions about your investments made, and who made them? If you have had no personal experience with investing, explain your reasons. What reasons might you have for investing (or not) in the future? 2. About how many stock exchanges exist in the world? Which geographic region has the greatest number of exchanges? Sample features of stock exchanges on each continent at http://www.tdd.lt/slnews/ Stock_Exchanges/Stock.Exchanges.htm. What characteristics do all the exchanges share? 3. What is a brokerage house, and when would you use a broker? Find out at http://www.wisegeek.com/ what-is-a-brokerage-house.htm. Sample brokerage houses that advertise online. What basic products and services do all brokerages offer? According to the advice at http://gti.cuna.org/18592/worksheets/ evaluate_broker.pdf, what is the best way to choose a broker? Discuss brokers with classmates to develop a list of ten questions you would want to ask a broker before you opened an account. (Hint: Search the Motley Fool’s 2009 “Brokerage Questions for Beginners” at http://www.fool.com.) 4. Visit the Chicago Mercantile Exchange at http://www.cmegroup.com/. What are some examples of commodities on the CME that theoretically could be part of your investment portfolio? In what energy product does the CME specialize? Could you invest in whether a foreign currency will rise or fall in relation to another currency? Could you invest in whether interest rates will rise or fall? Could you invest in how the weather will change? 5. An example of financial engineering is the derivative known as the credit default swap, a form of insurance against defaults on underlying financial instruments—for example, paying out on defaults on loan payments. According to Senator Harkin’s (D-Iowa) 2009 report at http://www.iowapolitics.com/ index.iml?Article=160768, why must derivatives like credit default swaps and their markets be more rigorously regulated? Regulation is a perennial political issue. What are some arguments for and against the regulation or deregulation of the capital markets? What are the implications of regulation and deregulation for investors? 2. INVESTMENT PLANNING L E A R N I N G O B J E C T I V E S 1. Describe the advantages of the investment policy statement as a useful framework for investment planning. 2. Identify the process of defining investor return objectives. 3. Identify the process of defining investor risk tolerance. 4. Identify investor constraints or restrictions on an investment strategy. Allison has a few hours to kill while her flight home is delayed. She loves her job as an F I G U RE 1 2 . 5 analyst for a management consulting firm, but the travel is getting old. As she gazes at the many investment magazines and paperbacks on display and the several screens all tuned to financial news networks and watches people hurriedly checking their stocks on their mobile phones, she begins to think about her own investments. She has been paying her bills, paying back student loans and trying to save some money for a while. Her uncle just died and left her a bequest of $50,000. She is thinking of investing it since she is getting by on her salary and has no immediate plans for this windfall. Allison is wondering how to get into some serious investing. She is thinking that since so many people seem to be interested in “Wall Street,” there must be money in it. There is no lack of information or advice about investing, but Allison isn’t sure how to get started. Allison may not realize that there are as many different investment strategies as © 2010 Jupiterimages Corporation there are investors. The planning process is similar to planning a budget plan or savings plan. You figure out where you are, where you want to be, and how to get there. One way to get started is to draw up an individual investment policy statement. Investment policy statements, outlines of the investor’s goals and constraints, are popular with investment policy institutional investors such as pension plans, insurance companies, or nonprofit endowments. Institustatement tional investment decisions typically are made by professional managers operating on instructions A structured framework for from a higher authority, usually a board of directors or trustees. The directors or trustees may approve investment planning based the investment policy statement and then leave the specific investment decisions up to the professional on the investor’s return objectives, risk tolerance, and investment managers. The managers use the policy statement as their guide to the directors’ wishes and constraints. concerns. This idea of a policy statement has been adapted for individual use, providing a helpful, structured framework for investment planning—and thinking. The advantages of drawing up an investment policy to use as a planning framework include the following: The process of creating the policy requires thinking through your goals and expectations and adjusting those to what is possible. < The policy statement gives you an active role in your investment planning, even if the more specific details and implementation are left to a professional investment advisor. < Your policy statement is portable, so even if you change advisors, your plan can go with you. < Your policy statement is flexible; it can and should be updated at least once a year. < A policy statement is written in two parts. The first part lists your return objectives and risk preferences as an investor. The second part lists your constraints on investment. It sometimes is difficult to reconcile the two parts. That is, you may need to adjust your statement to improve your chances of achieving your return objectives within your risk preferences without violating your constraints. 2.1 Defining Return Objective and Risk Defining return objectives is the process of quantifying the required annual return (e.g., 5 percent, 10 percent) necessary to meet your investment goals. If your investment goals are vague (e.g., to “increase wealth”), then any positive return will do. Usually, however, you have some specific goals—for example, to finance a child’s or grandchild’s education, to have a certain amount of wealth at retirement, to buy a sailboat on your fiftieth birthday, and so on. Once you have defined goals, you must determine when they will happen and how much they will cost, or how much you will have to have invested to make your dreams come true. As explained in Chapter 4, the rate of return that your investments must achieve to reach your goals depends on how F I G U RE 12 . 6 © 2010 Jupiterimages Corporation risk tolerance An investor’s capacity for risk exposure, based on the ability and willingness to assume risk. much you have to invest to start with, how long you have to invest it, and how much you need to fulfill your goals. As in Allison’s case, your goals may not be so specific. Your thinking may be more along the lines of “I want my money to grow and not lose value” or “I want the investment to provide a little extra spending money until my salary rises as my career advances.” In that case, your return objective can be calculated based on the role that these funds play in your life: safety net, emergency fund, extra spending money, or nest egg for the future. However specific (or not) your goals may be, the quantified return objective defines the annual performance that you demand from your investments. Your portfolio can then be structured—you can choose your investments—such that it can be expected to provide that performance. If your return objective is more than can be achieved given your investment and expected market conditions, then you know to scale down your goals, or perhaps find a different way to fund them. For example, if Allison wanted to stop working in ten years and start her own business, she probably would not be able to achieve this goal solely by investing her $50,000 inheritance, even in a bull (up) market earning higher rates of return. As you saw in Chapter 10 and Chapter 11, in investing there is a direct relationship between risk and return, and risk is costly. The nature of these relationships has fascinated and frustrated investors since the origin of capital markets and remains a subject of investigation, exploration, and debate. To invest is to take risk. To invest is to separate yourself from your money through actual distance—you literally give it to someone else—or through time. There is always some risk that what you get back is worth less (or costs more) than what you invested (a loss) or less than what you might have had if you had done something else with your money (opportunity cost). The more risk you are willing to take, the more potential return you can make, but the higher the risk, the more potential losses and opportunity costs you may incur. Individuals have different risk tolerances. Your risk tolerance is your ability and willingness to assume risk. Your ability to assume risk is based on your asset base, your time horizon, and your liquidity needs. In other words, your ability to take investment risks is limited by how much you have to invest, how long you have to invest it, and your need for your portfolio to provide cash—for use rather than reinvestment—in the meantime. Your willingness to take risk is shaped by your “personality,” your experiences, and your knowledge and education. Attitudes are shaped by life experiences, and attitudes toward risk are no different. Figure 12.7 shows how your level of risk tolerance develops. F I G U RE 12. 7 Risk Tolerance risk averse An investor’s preference to minimize exposure to risk. Investment advisors may try to gauge your attitude toward risk by having you answer a series of questions on a formal questionnaire or by just talking with you about your investment approach. For example, an investor who says, “It’s more important to me to preserve what I have than to make big gains in the markets,” is relatively risk averse. The investor who says, “I just want to make a quick profit,” is probably more of a risk seeker. Once you have determined your return objective and risk tolerance (i.e., what it will take to reach your goals and what you are willing and able to risk to get there) you may have to reconcile the two. You may find that your goals are not realistic unless you are willing to take on more risk. If you are unwilling or unable to take on more risk, you may have to scale down your goals. 2.2 Defining Constraints Defining constraints is a process of recognizing any limitation that may impede or slow or divert progress toward your goals. The more you can anticipate and include constraints in your planning, the less likely they will throw you off course. Constraints include the following: Liquidity needs Time available < Tax obligations < Legal requirements < Unique circumstances < < Liquidity needs, or the need to use cash, can slow your progress from investing because you have to divert cash from your investment portfolio in order to spend it. In addition you will have ongoing expenses from investing. For example, you will have to use some liquidity to cover your transaction costs such as brokerage fees and management fees. You may also wish to use your portfolio as a source of regular income or to finance asset purchases, such as the down payment on a home or a new car or new appliances. While these may be happy transactions for you, for your portfolio they are negative events, because they take away value from your investment portfolio. Since your portfolio’s ability to earn return is based on its value, whenever you take away from that value, you are reducing its ability to earn. Time is another determinant of your portfolio’s earning power. The more time you have to let your investments earn, the more earnings you can amass. Or, the more time you have to reach your goals, the more slowly you can afford to get there, earning less return each year but taking less risk as you do. Your time horizon will depend on your age and life stage and on your goals and their specific liquidity needs. Tax obligations are another constraint, because paying taxes takes value away from your investments. Investment value may be taxed in many ways (as income tax, capital gains tax, property tax, estate tax, or gift tax) depending on how it is invested, how its returns are earned, and how ownership is transferred if it is bought or sold. Investors typically want to avoid, defer, or minimize paying taxes, and some investment strategies will do that better than others. In any case, your individual tax liabilities may become a constraint in determining how the portfolio earns to best avoid, defer, or minimize taxes. Legalities also can be a constraint if the portfolio is not owned by you as an individual investor but by a personal trust or a family foundation. Trusts and foundations have legal constraints defined by their structure. “Unique circumstances” refer to your individual preferences, beliefs, and values as an investor. For example, some investors believe in socially responsible investing (SRI), so they want their funds to be invested in companies that practice good corporate governance, responsible citizenship, fair trade practices, or environmental stewardship. Some investors don’t want to finance companies that make objectionable products or by-products or have labor or trade practices reflecting objectionable political views. Divestment is the term for taking money out of investments. Grassroots political movements often include divestiture campaigns, such as student demands that their universities stop investing in companies that do business with nondemocratic or oppressive governments. Socially responsible investment is the term for investments based on ideas about products or businesses that are desirable or objectionable. These qualities are in the eye of the beholder, however, and vary among investors. Your beliefs and values are unique to you and to your circumstances in investing and may change over time. Having mapped out your goals and determined the risks you are willing to take, and having recognized the limitations you must work with, you and/or investment advisors can now choose the best investments. Different advisors may have different suggestions based on your investment policy statement. The process of choosing involves knowing what returns and risks investments have produced in the past, what returns and risks they are likely to have in the future, and how the returns and risks are related—or not—to each other. divestment The sale of an asset to reverse an invested position. socially responsible investment An investment strategy to achieve both ethical and financial goals. K E Y < < < < < < < < < < < < < the process of creating the policy requires thinking through goals and expectations and adjusting those to the possible; the statement gives the investor an active role in investment planning, even if the more specific details and implementation are left to a professional investment advisor; the statement is portable, so that even if you change advisors your plans can go with you; the statement is flexible; it can and should be updated at least once per year. Return objectives are defined by the investor’s goals, time horizon, and value of the asset base. Risk tolerance is defined by the investor’s ability and willingness to assume risk; comfort with risk taking relates to personality, experience, and knowledge. Constraints or restrictions to an investment strategy are the investor’s < < T A K E A WA Y S The investment policy statement provides a useful framework for investment planning because liquidity needs, time horizon, tax circumstances and obligations, legal restrictions, unique preferences or circumstances. Social investment and divestment are unique preferences based on beliefs and values about desirable or objectionable industries, products, or companies. Your investment policy statement guides the selection of investments and development of your investment portfolio.