​Investment -  Types and Characteristics of Investors
Introduction to Investor Types 

Investors are not a homogeneous group; both individual and institutional investors have diverse features. Clients differ in terms of their financial resources, objectives, personalities, financial expertise, and so on. These variances affect their financial demands, what services they require, and what assets are appropriate for them. Consider the following example:
Elderly customers with significant resources may be highly concerned with estate planning.
Elderly consumers with little resources may be more anxious about outliving their assets.

Thus, a gap in investment returns may have major ramifications for people concerned about outliving their assets but have less impact on those with significant resources. 

Investors can own securities, such as shares and bonds, directly, or they can invest in professionally managed funds to acquire market exposure. Investors may choose securities or funds themselves or contact an investment professional to aid in the decision. Investment experts attempt to provide appropriate investment services to fulfill clients’ demands. 

The most basic distinction among investors is that between individual and institutional investors. 

INDIVIDUAL INVESTORS
Individual investors trade (buy or sell) securities or permit others to trade stocks for their personal accounts.

INSTITUTIONAL INVESTORS
Institutional investors are organisations that hold and manage portfolios of assets for themselves or others. 

The traits that distinguish individual investors are frequently distinct from those that define institutional investors. 

Individual Investors
Individual investors are often differentiated based on their resources. The word ‘retail investor’ can be used to refer to all individual investors, although it is typical to use the term to refer to individual investors with little resources to invest. Many investing businesses create a distinction between their regular clients, more affluent clients with higher amounts to invest, and high- and ultra-high-net-worth investors, who have the biggest amounts of investable assets. 

The services supplied by investment businesses and the investments available will often vary by the amount of money the client has to invest. Some specialist funds may need minimum quantities of investment (e.g., USD1 million), and some portfolio management services may have minimum costs, rendering them uneconomical for lesser account sizes.

An investment firm that focuses on retail investors has to satisfy the needs of a large number of relatively modest accounts. Doing so often implies consolidating the retail investors’ assets into a smaller number of funds and establishing automated systems for the administration of client fund holdings.

An investment firm or division within an investment firm specializing on high-net-worth investors may have fewer clients, but greater average account balances, than one that concentrates on regular investors. Investor assets may still be placed in funds, however some high-net-worth investors will prefer their own segregated accounts (known as separately managed accounts). Wealthy clients may have higher expectations of client service than retail consumers, and usually the services that are delivered to them are more individualized.

Individual investors vary in their level of investment knowledge and competence. Some individual investors have very limited investment knowledge and competence, and others are more knowledgeable, maybe as a result of their schooling or work experience. 

Because individual investors are typically viewed of as less knowledgeable and less experienced than institutional investors, regulators in many countries try to safeguard them by setting restrictions on the assets that can be sold to them.  

For example, as of 2022 in the United States, the Securities and Exchange Commission (SEC) restricts investing in some alternative investments to accredited individuals. An individual qualifies as an accredited investor if they have earned income of USD200,000 or more in each of the prior two years and has a reasonable expectation to earn at least USD200,000 in the current year, or has (alone or together with a spouse) a net worth (excluding his or her primary residence) greater than USD1 million.

This restriction is based on the assumption that wealthier investors are anticipated to have a higher level of investing expertise — or access to professional investment counsel — and possess a greater ability to forgo investment liquidity.

Additional variables of the personal situations of individual investors, such as age and family obligations, may also differ and affect their investing demands and decision making. The planned holding term (time or investment horizon) for investments, risk tolerance, and other conditions also affect investors’ needs. 

Retail Investors
The investing sector delivers primarily standardised services to retail investors because they make the least money per investor for investment firms. Many retail investing services are supplied online or by customer service personnel working at call centres.

High-Net-Worth Investors
Wealthier investors often receive more personal attention from financial experts. Their investment problems sometimes involve tax and estate planning complications that demand greater resources and professional knowledge. They either pay directly for these services on a fee-for-service basis or indirectly through commissions and other transaction charges.

Ultra-High-Net-Worth Investors and Family Offices


Very affluent individuals generally employ professionals who help them manage their money, future estates, and legal concerns. These specialists generally operate in a family office, which is a private corporation that administers the financial affairs of one or more members of a family or of numerous families. 

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Many family offices serve the heirs of huge family fortunes that have been acquired over generations. In addition to investing services, family offices may provide personal services to the family members, such as bookkeeping, tax planning, managing household personnel, making travel arrangements, and coordinating social events.

Wealthy families generally have huge real estate holdings and large financial portfolios. The investment professionals who work in family offices often handle these investments using the same strategies and processes that institutional investors use. They pay especially close attention to personal and estate tax issues that may considerably affect the family’s wealth and their capacity to transfer money on to future generations or charity institutions.

Institutional Investors


Institutional investors are organisations that hold and manage portfolios of assets for themselves or others. There are numerous different sorts of institutional investors with differing investment criteria and limits. Institutional investors may invest to promote their mission, or they may invest for others to address the others’ needs. Institutional investors that invest to achieve their missions include the following:
Pension plans
Endowment funds and foundations
Trusts
Governments and sovereign wealth funds
Non-financial companies

Institutional investors that invest to provide financial services to their clients include investment companies, banks, and insurance companies. Some institutional investors handle their investments internally and employ investment specialists whose duty is to select the investments. 

Other institutional investors outsource the investing of the portfolio to one or more external investment firms. The choice between internal and external management will frequently be influenced by the size of the institutional investor, with larger institutional investors better able to afford the resources required for internal management.

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Some institutional investors will choose a mixed model, managing some assets domestically in which they have competence and outsourcing more specialist investments — for example, alternative investments — to external managers. Those institutional investors that choose to outsource investment management still have significant decisions to make in terms of which managers to choose. They may use internal expertise to make manager selection decisions, or they may employ a consultant.

Pension Plans
Pension plans hold investment portfolios — that is, pension funds — for the benefit of future and existing retired members, who are called beneficiaries.

A firm or other body may set up a pension plan to provide benefits to its employees. The companies and governments that sponsor these plans are termed pension sponsors or plan sponsors. Money from employer and/or employee contributions is placed away to give income to plan members when they retire. The payments must be invested until the employee retires and receives the retirement benefits.

Pension plans differ by whether they are arranged as defined benefit or defined contribution schemes. 

Defined Benefit Pension Plans
Defined benefit pension schemes promise a defined annual sum to their retired participants. The set amount normally fluctuates by member based on such factors as years of service and annual income while working. 

Typically, employees do not have the right to collect benefits until they have worked for the company or government for a term set by the pension plan. An employee’s rights are vested (covered by law or contract) once they have worked for that duration.

Defined benefit pension funds, particularly those of government-sponsored schemes, are among the largest institutional investors. Pension funds may invest in equities securities, debt securities, and alternative assets because they often have relatively lengthy time horizons. 

As employees retire, new employees are added to the plan. If new employees are not being added to the plan, the temporal horizon of the plan will diminish over time.

In a defined benefit pension plan, the sponsoring employer promises its members (or employees) a defined amount of benefit. For example, it is extremely typical for the company to promise a yearly pension that is a specified proportion of the employee’s final pre-retirement income. 

The pension may be adjusted for inflation over time. The employer will pay contributions to the pension fund to honor the promise. Employees may also be asked to donate.

In a defined benefit plan, the employer bears the risk – in this example, that the investments made by the pension fund fail to perform as predicted. If the investments fail to perform as planned, the employer may be obliged to make further contributions to the fund. 

But it is likely that pension sponsors will be unable to make the necessary contributions and that beneficiaries would not receive the benefits expected. Defined benefit plans are becoming less widespread around the globe and are being replaced by defined contribution plans.

Euro Pension Fund is the fund for a defined benefit pension plan located in Frankfurt, Germany. The plan sponsor remits money to the fund based on projections of pension benefit commitments compared with pension plan assets. Working members of the plan also pay a portion of their wages to the fund. 

It has an asset management team that devises the fund’s strategy and implements it. 

Defined Contribution Pension Plans
In a defined contribution pension plan, the pension sponsor normally contributes an agreed-on amount — the defined contribution — to an account set up for each employee. 

Employees also often contribute to their own retirement plan accounts, primarily through employee payroll deductions. 

The contributions are subsequently invested, generally in funds that the employee chooses from a list of approved funds inside the plan. 

The plan gives enough options of funds to allow employees to establish a broadly diversified portfolio. The sponsor often limits the selections to a group of mutual funds sponsored by recognized investment managers. The pension plan sponsor should also guarantee that the costs levied on the funds are appropriate. At retirement, the money that has accumulated in the account is available to the employee.

In defined contribution plans, the member (or employee) takes the risk that the pension account’s investments fail to perform as predicted. This contrasts with defined benefit plans, in which the employer takes the risk. 

In defined contribution plans, the employer has no commitment to make further payments if the investments perform poorly. If the retirement fund is less than projected, the employee may have to make do with less retirement income or, maybe, defer retirement.

Because saving enough and choosing the correct investments are very important, defined contribution plan sponsors are increasingly providing financial assistance to their beneficiaries or arranging for financial consultants to help guide members.

In the past, most pension plans were defined benefit pension plans. Because these plans promise defined benefits to their beneficiaries, they are expensive responsibilities for the sponsor (company) and many sponsors no longer offer them. This development explains why defined contribution pension plans are progressively replacing defined benefit plans in most countries.

Endowment Funds and Foundations


Endowment funds and foundations are also big institutional investors in many nations. Endowment funds are long-term funds of nonprofit institutions, such as universities, hospitals, and museums. 

These institutions use their endowment monies to provide some services to their students, patients, and supporters. Foundations are grant-making institutions funded by gifts and by the investment income that they earn. Most foundations do not directly provide services. Instead, they fund entities that provide services in such areas as the arts or charities. Foundations often own endowment funds, which invest the foundation’s money.

Endowment funds and foundations often have a charity or philanthropic aim and accept endowments from contributors interested in supporting their activities. In many countries, gifts to these institutions are tax deductible for the donors. 

That is, gifts diminish the income on which the donors have to pay taxes. Investment income and capital gains that these organisations get from investing these funds may also be tax-exempt.

Endowment funds are normally meant to remain in perpetuity and, as such, are viewed as very long-term investors. But they are also often mandated to spend annually on the benevolent or philanthropic objective for their existence, therefore money needs to be pulled from their funds. 

Many endowment funds and foundations adopt spending criteria; for example, they may set expenditure goals of a percentage range of their assets. Often, their issue resides in combining long-term growth with shorter-term income or cash flow requirements.

Each endowment fund or foundation has its own special circumstances. Some are able to raise money on an ongoing basis, but others are limited from raising more money. Some endowment funds and foundations are mandated to spend a fixed part of the portfolio each year, whilst others have more flexibility to adjust spending. 

These discrepancies have significance for how the institutional investor’s assets are invested. An endowment client that is barred from fundraising has to meet its financial needs from income or the sale of assets, whereas an endowment client that has no restriction on fundraising may also raise money to satisfy its financial needs.

Most institutions with endowment funds use professional investment managers to manage the funds. Some manage portions of their money domestically, in some cases through an investment management company that they control. 

Governments and Sovereign Wealth Funds


Governments receive money from collecting taxes or selling bonds. When they do not have to spend this money immediately, they frequently invest it. 

Some governments have accumulated significant surpluses from selling natural resources that they control or from financing the trade of goods and services. They create sovereign wealth funds to invest these surpluses for the benefit of present and future generations of their citizens.

Sovereign wealth funds often invest in long-term securities and assets. They also may purchase companies. Sovereign wealth funds either manage their investments in-house or engage investment managers to manage their money.

Non-Financial Companies
Analysts typically identify companies as either financial companies or non-financial companies. 

Financial Companies
Financial companies include investment companies, banks and other lenders, and insurance organizations. These companies provide financial services to its clientele.

Non-Financial Companies
Non-financial enterprises produce items and non-financial services for their consumers. 

These companies invest money that they do not presently require to run their businesses.

The money invested by non-financial companies may be invested short-term, mid-term, or long-term. The corporate treasurer usually controls the short-term investment assets. These assets often comprise cash that the company will need shortly to pay salaries and accounts payable and financial vehicles that are safe and liquid, like demand deposits (checking accounts), money market funds, and short-term debt securities issued by governments or other companies. 

Long-term investments are normally managed under the leadership of the chief financial officer or the chief investment officer, if the company has one. firms often invest long term to finance future research, investments, and acquisitions of firms and goods. Companies may invest long term directly, or they may hire investment managers to invest on their behalf.

Some corporations invest directly in the shares and bonds of their suppliers and in the shares of possible merger partners to strengthen their relationships with them. Practitioners term these investments ‘strategic investments’. These types of investments are widespread in Asian countries, such as Japan and South Korea, and in European countries, such as France, Germany, and Italy.

Investment Companies

Investment businesses include mutual funds, hedge funds, and private equity funds. These firms operate exclusively to hold investments on behalf of its owners, partners, or unitholders (units refer to shares and bonds for equity and debt securities, respectively). These companies are called pooled investment vehicles because investors in these organizations pool their money for common management. 

Investment companies are handled by experienced investment managers that work for investment management organizations. These management businesses often structure and market the investment companies that they manage and so function as the investment sponsors.

Mutual funds pool the assets of many investors into a single investment vehicle, which is professionally managed and benefits from economies of scale. There are thousands of mutual funds administered by investment management businesses. 

Mutual funds are often classed by their investment(s). Investments eligible for inclusion may be strictly or broadly defined and based on categories of assets, geographic area, and so on.

For example, mutual funds may specify that they invest in Chinese equities identified as having growth potential, global equities, long-term investment-grade European corporate bonds, or commodities. The investment management business receives a fee for managing the fund. Although a mutual fund can be viewed as an institutional investor, the phrase ‘mutual fund’ also refers to the investment vehicle, shares of which an individual or institutional investor might hold in a portfolio.

Hedge funds and private equity funds can similarly be considered institutional investors that manage private investment pools and as investment vehicles. They are distinguished by their use of tactics outside the limits of most standard mutual funds (discussed in Course 2, Types and Functioning of Markets).

Insurance Companies


Insurance companies form another key group of institutional investor. 

Insurance Companies collect premium from persons and companies they cover. Premium are required by insurance firms to offer insurance coverage for the policyholders. 

Some of the premiums are deposited into a reserve fund form which insurance coverage can be paid. The premiums in the reverse funds are invested in broad portfolios of securities and assets that attempt to ensure that adequate money are always available to meet all claims. 
Regulations typically impose rules to restrict the types of investments insurance firms can keep. 

Insurance firms profit from the income they gain form float which is the amount money they have available to use after receiving premium and before paying claims.

There are two primary sorts of insurance businesses. 

PROPERTY AND CASUALTY
Property and casualty insurance firms safeguard their insured from the financial loss caused by such catastrophes as accidents and theft. 

Property and casualty insurers have short-term views and generally unpredictable payouts; therefore, they favor shorter-term assets that are more cautious and liquid. 

LIFE
Life insurance firms give payments to the policyholder’s beneficiaries in the event the policyholder dies while the insurance coverage is in force.

Life insurers have longer-term time horizons and more predictable payouts and, thus, have more leeway to engage in riskier assets. They frequently invest their reserve funds, which often are extremely big, in stocks, commodities, real estate, and other real assets.

Some insurance firms give both forms of insurance. 

nsurance businesses aim to match their investments to their responsibilities. For example, if they intend to make fixed annuity payments in the far future, they may invest in long-term fixed-income securities to match the interest rate risk of their assets to the interest rate risk of their liabilities. 

This approach of matching investment assets to liabilities, called asset/liability matching, decreases the risk that the company would fail to fulfill its claims.  



Most large insurance companies manage their investments in-house. They also may contract with investment managers to oversee specialty investments in industries, asset classes, or geographical regions where they lack expertise or access. 

Investors — both individual and institutional — differ in their financial resources, circumstances, objectives, views, financial skills, and so on. These distinctions determine what services the client requires and what types of investments are appropriate for the client. Therefore, it is crucial to record information about the client and the client’s needs.

​Investment - Investment Policy Statements
It is good practice to record information about the client and the client’s needs in an investment policy statement (IPS). An IPS, for both individual and institutional investors, acts as a guide for the investor and investment manager or adviser regarding what is required of and acceptable in the investment portfolio. An IPS also forms the basis for establishing what constitutes success in managing the portfolio.

The IPS should incorporate the investor’s objectives and any limits that will apply to the portfolio. The investor and manager/adviser should agree on the IPS and evaluate it on a regular basis, often once a year. It should also be revisited when the client encounters a change in circumstances. Creating and revising an IPS is a wonderful opportunity for the investment manager and client to discuss the client’s goals.

A common format for an IPS is to split it into sections covering objectives and restrictions. Each section has its own subsections. The IPS identifies the investor’s conditions and ambitions within the categories of needs and differences described in this course. 

Objectives
Return requirement
Risk tolerance

Constraints
Time horizon Liquidity
Regulatory restrictions
Taxes
Unique conditions

A standard IPS comprises objectives and restrictions, but many investors, especially institutional investors, may additionally include procedural and governance issues in the IPS. 

The IPS may spell out the role of an investment committee along with its organization and its jurisdiction. It may also lay out the functions of investment managers along with the grounds on which they will be appointed and the criteria on which they will be assessed.

An important aspect of the IPS is to give information that is valuable in determining the types and amounts of assets in which to invest and the way the portfolio will be managed over time.

So, the IPS serves as the basis for developing the optimal portfolio strategies and asset allocations.

Institutional Investors and the Investment Policy Statement


Most institutional investors design and employ a thorough IPS. These statements specify several of the following points:

The overall aims (including return objectives) of the investment strategy and its relevance to the mission of the institution

The risk tolerance of the organisation and its capability for carrying risk

All economic and operational constraints, such as tax concerns, legal and regulatory circumstances, and any other particular requirements

The time horizon over which funds are to be invested

The relative importance of capital preservation and capital growth

The asset types in which the institution is allowed to invest

A target asset allocation that states what proportion of the investment funds will be invested in each asset class


Whether leverage (use of debt) or short positions are authorized

How actively the institution will trade

How investment decisions will be made

The benchmarks against which the institution will measure total investment returns

After the IPS is prepared and required points addressed, the board of the institution or its senior leadership formally accepts the investment and payout policies.

The investment leaders then select whether to handle investments in-house or to contract with one or more investment managers. 

Institutional investors that handle their investments in-house hire a team of investment specialists to manage their investments.

Institutional investors who hire outside investment managers may use one manager to oversee all investments or numerous managers. Institutional investors generally use numerous managers to lessen the risk of considerable loss as a result of poor performance by any one manager. Many institutional investors utilize distinct managers for each asset class in which they invest. 

By engaging managers who specialise in particular asset classes, the institutional investors receive investment experience and access to investments that a generalist might not have.

​Investment - Risk and Portfolio Diversification 
An investment policy statement (IPS) captures information about a customer and the client’s needs. The IPS provides as a reference to what is demanded of and what is acceptable in the investment portfolio. The IPS helps guide asset allocation — that is, which asset classes and how much of each asset class should be included in the investor’s portfolio.

Academic research have suggested that asset allocation is the most important factor of portfolio return. Most investors — both individual and institutional — keep a broad range of investments rather than a portfolio concentrated in just a few investments. A fundamental reason for this diversity is the need to manage risk, which is congruent with the aphorism to not ‘put all your eggs in one basket’.  


Systematic Risk, Specific Risk, and Diversification 


How well investment risk is managed is a crucial factor of the success of investment management. Risk occurs when there is uncertainty, implying that a variety of outcomes are possible from a single scenario or activity.

In financial terminology, risk is the potential that the actual realised return on an investment will be something other than the return originally predicted on the investment. There will be instances when the return fails to match an investor’s expectations and times when the return exceeds expectations. Fluctuations in the prices and values of investments (capital gains and losses) represent the risk of investing. Income (e.g., dividends and interest) may also differ from what was expected.


Most investors seek larger returns and reduced risks. That is, people desire better outcomes and more certainty, all other things being equal. The trade-off between risk and return is a key issue in investment management. Typically, the larger the risk of an investment, the higher the expected return; the lower the risk, the lower the expected return. 

Systematic and Specific Risk

The returns on investments, such as equities, bonds, and real estate, will be affected by overall economic conditions. Returns will also be affected by issues that are specific to the particular investment. 

Systematic risk
The risk caused by general economic conditions is characterized as systemic or market risk since the danger emanates from the wider economic system. For example, if the economy enters a recession, many companies will notice a fall in their revenues and profits.

Specific risk
Risk that is distinctive to a certain firm or investment is variously termed as specific, idiosyncratic, non-systematic, or unsystematic risk. Examples include the positive share price response when a company releases a successful new product (e.g., the Apple iPad) or the negative response to the news that a promising new treatment has failed in trials. 

The distinction between systemic and specific risk is essential because the two categories of risk have different implications for investors. Investors can lower specific risk by holding a number of different securities in their portfolios. Holding a variety of securities that are not associated diversifies away specific risk. The amount to which two asset classes (or securities) move together is indicated by the statistical measure of correlation.The stronger the correlation between the returns on asset classes (or securities), the more comparable their price movements will be.  


Investors cannot diversify away systematic risk. They can do nothing to minimize systematic risk because all investments will be influenced to some extent by systematic risk — for instance, a recession. Diversifying an equity portfolio by adding alternative forms of investments, such as real estate, will not eliminate systematic risk because rents and real estate values are affected by the same broad economic variables as the stock market.


Because systematic risk cannot be avoided or spread away and because risk is undesirable, investors have to be compensated for taking on systematic risk. More exposure to systemic risk tends to be associated with higher predicted returns over the long run.  

Portfolio theory implies that taking on more specific risk does not necessarily lead to higher returns on average because specific risk can be diversified away. But some investors may try to locate shares that they think to outperform (to produce higher returns than predicted based on their risk) and invest in them rather than diversifying. In the process, investors take on specific risk; if they turn out to be correct, they may get a bigger return as a result of taking on more risk. 

Diversification 

Diversification is one of the most important aspects of investing. When assets and/or asset classes with varied characteristics are mixed in a portfolio, the overall level of risk is often lowered.

Mathematically, a portfolio that combines two assets has an expected return that is the weighted average of the returns on the individual assets. Provided that the two assets are less than completely linked, the risk of the portfolio (measured by the standard deviation of returns) will be smaller than the weighted average of the risk of the two assets individually. Overall, this indicates the risk–return trade-off, which is a key issue for investors, is better for a portfolio of assets than for individual assets.

Most investors have more than two securities in their portfolios. Adding more assets to a portfolio will lower risk through diversification, although eventually the additional benefits begin to lessen. The exhibit below demonstrates the degrees of risk — total, particular, and systematic — for portfolios of shares picked at random from all of the shares in the US market. 

Specific risk is decreased by merging additional shares, but as the portfolio moves beyond 30 shares, the incremental risk reduction becomes minimal and the accompanying trading expenses may outweigh any incremental advantage of risk reduction. The display illustrates the ideas of unique risk and diversification. Specific risk is highest at the left side of the exhibit (one share) and lowest at the right side of the display since much of the specific risk is spread away.

Portfolio Risk 
The display assumes randomly picked shares. But there is the potential for higher risk reduction when shares with low correlation with each other are chosen. 

Combining diverse asset classes can also boost diversification and lower a portfolio’s risk by minimizing specific risk. For example, an investor can combine assets in multiple stock and bond markets with investments in real estate and commodities to lower the overall risk of a portfolio. 

​Investment - Asset Allocation and Portfolio Construction 

After generating the investment policy statement (IPS), which comprises — among other facts — an investor’s desire and ability to take risk, the asset allocation of the portfolio is defined.

This determination entails decisions regarding whether asset classes are suitable (e.g., global stocks, domestic government bonds, commodities, or domestic real estate investment trusts) and the proportion of the portfolio to invest in each asset class. In some circumstances, the asset distribution decision is documented as part of the IPS; in other cases, asset allocation is recognized as part of the following execution of the IPS.

The chosen strategic asset allocation is intended to match the investor’s long-term risk and return objectives. An investor may determine the strategic asset allocation and simply keep a portfolio for the life of the investment. If the investor does so, the proportions of the portfolio will likely vary from the original weights specified because the different asset classes provide different rates of return over time and their values thus increase or fall by different amounts. As a result, the portfolio has to be changed through a process called rebalancing. 

Rebalancing entails selling some of the assets that have increased as a proportion of the portfolio and putting the proceeds into the holdings that have declined as a proportion of the portfolio. Because there are trading costs connected with rebalancing, most investors will not rebalance on a continuing basis, but will instead rebalance at specified intervals or weightings. 

Tactical Asset Allocation 
Although the chosen strategic asset allocation is expected to match the investor’s objectives over the long term, there are instances when shorter-term changes in asset class returns can be utilized to potentially boost portfolio returns. A short-term change among asset classes is known as tactical asset allocation.  

Strategic Asset Allocation 
Strategic asset allocation is the long-term mix of assets that is expected to suit the investor’s objectives. The desired overall risk and return profile of the portfolio is a consideration in selecting the strategic asset allocation. A portfolio with a strategic asset allocation dominated by stocks would be expected to have a greater return and be more volatile than a portfolio dominated by bonds because bonds normally have lower risk than equities and so provide lower returns. The strategic asset allocation that is suitable for one investor may not be suitable for another.

Academic research have revealed that strategic asset selection considerably affects the average return of a portfolio. Thus, asset allocation demands considerable attention from investors, investment managers, and investment counselors. Consider the following example of strategic asset allocation.

Example: Strategic Asset Allocation 
An institutional investor requires a 7% return on its investments. The investing committee decides to invest in global equities and in European government bonds. At the time the investment is made, European government bonds are yielding 4%, and the committee’s projection for the long-term return on the global equities market is 9%. 

A portfolio allocation of 40% bonds and 60% equity generates an estimated return of 7%: (0.40 × 0.04) + (0.60 × 0.09) = 0.07 or 7% 

The committee has to examine the level of risk suggested by this asset allocation. If the committee is not comfortable with the risk, the return criterion may need to be adjusted. The portfolio composition can be modified as bond yields vary and the committee revises its forecasts for the return on the global equity.

Strategic asset allocation often involves investment managers to evaluate the projected risk and return of each asset type. Historical returns can be used as a guide, but forecasts need to be forward-looking. Managers also need to establish the correlation of returns between the asset classes so they can quantify the diversification benefits that may be realized by combining the various assets in a portfolio.  

To illustrate, we will extend the preceding scenario in which an investor has a strategic asset allocation of 60% global equities and 40% European government bonds. The investment manager may think the global equities market is overvalued and likely to provide bad returns in the short run. In response, the manager could modify the asset allocation to, for example, 50% equities and 50% bonds. If the manager’s forecast is true, this 50/50 tactical allocation will perform better in the near term than the strategic asset allocation of 60/40. The management will have added return for the investment compared with maintaining the strategic weights on a static basis. 

But anticipating markets is tough, and tactical allocation does not always favor the investor. The difficulty of financial forecasting means investors may prefer to retain their strategic asset allocation within established parameters. For example, an appropriate strategic asset allocation may be judged to be 56%–64% global stocks and 36%–44% European government bonds, rather than 60% global equities and 40% European government bonds. Such ranges allow for some tactical asset allocation and lessen the need for and expense of frequent portfolio rebalance.  

An investor or manager often employs a range of tools and information to make tactical allocation decisions. The decisions may be based on one of the following:  

Fundamental studies of economic and political factors and their probable effects on market returns 
Market value measures relative to prior data 
Trends and momentum in marketplaces 

When considering tactically adjusting a portfolio’s asset allocation, a manager may look at the strength of the economy and expected future trends to acquire a view on how the central bank might change interest rates and on what might happen to company profits. The manager may next look at the level of the price-to-earnings ratio of the stock market and how it compares with recent decades as a measure of valuation or with the level of bond yields relative to historical ranges. The management could also look at stock and bond market patterns as a way of measuring investor mood. 

Tactical asset allocation represents an attempt to enhance value to a portfolio by departing from the strategic asset allocation. Tactical asset allocation is a form of active portfolio management.

​Investment - Value at Risk
Companies in the financial services industry believe that the assets and securities they possess will provide them with a positive return. But they also need to quantify the possible loss on an investment if their expectations for the asset or security turn out to be erroneous. This potential loss is commonly assessed using a metric known as value at risk.

Use and Advantages of Value at Risk


Value at risk (VaR) was developed in the late 1980s and is now a commonly used statistic. It relies on statistical notions, such as standard deviation. 

VaR gives an estimate of the least loss of value that may be predicted for a certain duration with a given level of probability.

For example, an asset management firm may estimate that a portfolio has a VaR of USD1 million for one day with a probability of 5%. This estimate suggests that there is a 5% risk that the portfolio will fall in value by at least USD1 million in a single day, assuming no further trading. In other words, a loss of USD1 million or more for this portfolio is likely to occur, on average, once in 20 trading days (1/0.05).

VaR offers various advantages:

It is a common statistic that can be utilized across diverse assets, portfolios, business units, businesses, and markets.


It is relatively easy to compute and well understood by senior managers and directors.


It is a valuable tool for risk budgeting if there is a common procedure for allocating capital across business units according to risk.

It is widely utilized and mandated for usage by several regulators.

Weaknesses of VaR There are also limitations inherent in the VaR measure of risk. VaR gives an estimate of the least, but not the maximum, loss of value that can be predicted. Referring back to the preceding scenario, the asset management business can expect a loss of at least USD1 million 12 or 13 times a year (5% of the about 250 trading days a year). VaR does not represent the highest loss of value the portfolio manager may anticipate to sustain in one day, and it does not guarantee that a loss in excess of USD1 million will not occur more frequently than a dozen times a year.

In fact, VaR generally underestimates the frequency and amount of losses, mostly due to erroneous assumptions and models. 

First, VaR mostly depends on previous data to anticipate future expected losses. But past returns may not be a strong indicator of future returns. In addition, history is not helpful in forecasting occurrences that have far-reaching repercussions, but are unforeseen or deemed impossible – that is, black swan events.


Second, VaR makes an assumption regarding the distribution of returns. 


For example, it is typically believed that returns are regularly distributed and follow the bell-shaped distribution. The use of historical data and the assumption of a normal distribution may perform quite effectively in normal market conditions but not during periods of market upheaval.

The global financial crisis of 2008 is a case in point. Until 2007, most banks had a low daily VaR, which provided them a false sense of security. Once the crisis hit, the number of days when trading losses exceeded the daily VaR and the magnitude of those losses were much larger than projected. Some banks stated that the frequency of losses was 10 to 20 times higher than the VaR estimates, and some banks experienced losses that considerably depleted their equity capital.

To counter these limitations, firms, particularly banks, often adopt alternative risk management approaches in addition to VaR. These complementing techniques include scenario analysis and stress testing, which focus on the influence of more extreme events that would not be adequately captured or examined by VaR. 

For example, an asset management firm may perform a scenario analysis by identifying different scenarios for the economy (strong growth, moderate growth, slow growth, no growth, mild recession, and severe recession) and then determining how each scenario would affect the value of a portfolio and the firm’s earnings and equity capital.


The firm may also engage in stress testing by evaluating the consequences of extreme market conditions, like as a liquidity crisis, to make sure that it would be robust and survive the crisis.

 It is worth mentioning that the problems associated to VaR apply to all measurements that rely on models. The danger emerging from the usage of models is collectively known as model risk. This risk is related with improper underlying assumptions, the unavailability or inaccuracy of historical data, data problems, and misapplication of models.

​Investment - Compliance Risk
Compliance risk is the risk that a corporation fails to comply with all applicable rules, laws, and regulations. The risk of non-compliance with laws and regulations is higher than non-compliance with internal policies and processes because fines might be enforced. These fines can harm both individuals and companies and may be severe.

Ensuring compliance with rules and regulations has traditionally been considered as a pretty dull duty, but the quickly changing regulatory environment has in recent years propelled compliance to the forefront of company objectives. Many people believe that the tendency towards less regulation contributed to the global financial crisis that began in 2008. 

The tendency has reversed with the re-imposition of increased regulation and control. This additional law, in turn, has led to more compliance tasks and more compliance risk.

Framework for Legal and Regulatory Compliance

Every corporation has to obey a set of rules, beginning with the statutory laws and other restrictions imposed by regulatory agencies. In addition, many investment businesses must follow requirements from authorities, stock exchanges, and industry bodies that have been given responsibilities to regulate members. Because of their prominence in the financial system, banks and insurance businesses have historically been subject to severe supervision, with extensive rules and monitoring from regulatory bodies. For example, banks are subject to the Basel Accords.

Accords are international agreements that normally take the name of the location where they are signed. The Basel Accords, which specify worldwide norms for banks’ capital, leverage, and liquidity requirements, are considered regularly in Basel, Switzerland and revised as needed.

Complying with applicable rules and regulations is needed of every company. The repercussions of not doing so can be severe and can include financial penalties, loss of business licences, litigation by clients, and in catastrophic cases, prison terms. Often the greatest effects are the damage to the company’s reputation and the loss of present and potential commercial possibilities.

Companies should have internal reporting mechanisms to encourage employees to come forward and report incidents in which they feel someone has broken internal policies, procedures, laws, or regulations.


This technique is called whistleblowing. Whistleblowing has become an important tool for authorities to learn about infractions, and rules to protect and reward whistleblowers have been tightened in the wake of financial scandals.

Examples of Compliance Risks
Corruption, which is defined as the abuse of power for private gain, has attracted heightened attention because of tougher laws and regulations on bribery and greater regulatory monitoring, investigations, prosecutions, and fines. Some national authorities may apply these laws extra-territorially, even to overseas corporations. Firms that operate through agents and other third parties should be aware that their duty for combating corruption extends to the acts of these third parties. Ignoring the practices of third parties does not provide a defence in the case of a regulatory examination.

To safeguard against corruption, firms must start by establishing a tone at the top, with senior management conveying an unequivocal policy of zero tolerance for unethical business practices and bribery. 

Risk assessments should identify major risk areas and susceptible employees. For instance, personnel who contact with government officials for licensing or deal with government or state-owned enterprises should be given extra training and be supervised constantly. Controls over corporate gifts and hospitality, especially in payment-processing sectors, are vital for the prevention of unlawful or unethical payments.

Compliance with tax regulations is hard because the principles and standards vary widely by jurisdiction. Companies are continuously creating financial and legal structures, generally with the purpose of reducing taxes overall. Uncertainty arises in how tax authorities will apply their laws, which is heightened by the fact that the rules change constantly. A conservative approach is to conform to tried-and-tested precedents. A more aggressive approach is to seek to exploit loopholes in the tax code, low-tax jurisdictions (so-called offshore tax havens), and other grey areas.

There is a technical difference between ‘tax avoidance’, which involves employing tax code provisions to limit the tax that is owing, and ‘tax evasion’, which means not paying taxes in violation of the tax law. In practice, however, the border between tax avoidance and tax evasion is not always clear and specialist tax guidance is important. 

There are rules that restrict the trading of a security when in possession of critical sensitive information relevant to the security in question. Most markets have lately toughened legislation regulating insider trading. Another trend is an increase in investigations of insider trading; some such investigations are even relying on techniques similar to those used in investigations of organised crime cases — including tapping telephones, using evidence already collected to make peripheral suspects cooperate, and gradually closing in to catch the central participants of the scheme.

Companies must develop policies and procedures to ensure that traders understand the laws and that nobody in the organization will be in the position to break them. Investment organizations that face a high risk of insider trading, such as investment banks, use ‘control rooms’ to monitor information passing between teams. They also have virtual walls or information barriers to restrict and segregate information and to handle other conflicts of interest. 

Anti-money-laundering law is a set of measures to prohibit money produced from illicit activity from entering the financial system and obtaining the appearance of being acquired from legitimate sources. These rules require companies in the financial services industry, including those in the investment industry, to obtain sufficient original or certified documentation to perform a formal risk assessment on each client and counterparty; the procedures of such an assessment are called know-your-customer procedures.

International agreements defining basic principles and requirements for anti-money-laundering frameworks have been formed and are implemented with modest modifications according to the jurisdiction. A significant aspect of most anti-money-laundering rules is a severe liability approach to compliance. That is, a corporation might be liable to harsh consequences as a result of not following specified procedures and record keeping, regardless of whether any questionable transactions are handled or any actual damage is made.

​Investment - Investment Risk
Risk is a significant factor of financial decisions. Investors, for instance, buy equities securities, commodities, or real estate. When they do, they are subject to investment risk – that is, the risk connected with investing. For example, investors may experience losses if the company in which they bought common shares loses value or goes bankrupt, or if commodity or real estate values collapse. 

Investment risk can take numerous forms based on the company’s investments and operations. Companies in the investment industry often suffer three primary forms of investment risk.

Market risk is risk generated by changes in market conditions affecting prices.

Credit risk is the risk for a lender that a borrower fails to honour a contract and make timely payments of interest and principal.

Liquidity risk is the risk that an asset or security cannot be acquired or sold rapidly without a major sacrifice in price. 

A common feature for success in all sorts of investment risk management is the requirement to recognize the risks and price them appropriately.

Market Risk

Market risk, which originates from price movements in financial markets, can be categorized into the risks associated with the underlying market instruments:
Equity price risk
Interest rate risk (for debt securities)
Foreign exchange rate risk
Commodity price risk

Many investment firms are in the business of assuming investment risks, and they tend to tolerate market hazards. But like any other organization, they must align their risk profiles with their risk tolerance. They commonly adopt an approach called risk budgeting to establish how risk should be shared across different business units, portfolios, or individuals.

For example, an asset management business may apply the following risk budgeting steps:

Quantify the level of risk that can be carried by the firm
Set risk budgets and restrictions for each asset class and/or investment manager
Allocate assets in line with the risk budgets
Monitor to verify that risk budgets are respected

Market risks that cannot be tolerated must be managed, and companies have different solutions available. One of them is to hedge undesirable risks by employing derivative products.

Credit Risk


When analyzing the creditworthiness of borrowers, it is crucial to examine both their ability and willingness to repay their obligations.

For example, after the decrease in real estate prices in 2008, many homeowners in the United States were left with mortgage loan obligations that surpassed the market worth of the property. Some of those borrowers still had the means to keep paying their mortgage payments but elected to fail and let the bank take possession of the property.

This potentially unethical option is rational from a purely financial perspective, except from the lower credit profile for future borrowing.

The predicted loss from credit exposure is a function of three elements:
Amount of money lent to a given borrower
Probability that the borrower defaults
Loss that would be incurred if the borrower defaults

The amount that is at risk may be decreased if collateral or assurances from third parties are added. Enforcing contract restrictions to acquire possession of collateral, however, can be a time-consuming legal process. The value of collateral assets for a lender depends on their liquidity and marketability – that is, how easy it is to sell the assets to a third party and at how big of a discount if sold on short notice. Assets for which a consistent market demand exists and that can be moved and easily transferred are more valuable than assets that are exchanged less frequently and are less mobile.


Various sources of independent information exist on borrower creditworthiness, such as credit rating organizations, which should be used in conjunction with internal risk analysis. Any analysis, whether internal or external, should incorporate a degree of critical judgement and scepticism.

There are numerous techniques to managing credit risk:
EXPOSURE LIMITS
Credit risk can be managed by placing restrictions on the amount of exposure to a given counterparty or level of credit rating allowed. For example, a maximum limit of 5% exposure could be specified for a certain counterparty.

COLLATERAL AND COVENANTS
Credit risk can also be addressed by requesting more collateral and enforcing covenants. Covenants are terms for loans that describe both what a borrower must do (positive covenants) and what a borrower is not allowed to do (negative covenants). 

For example, a bank may prevent borrowers from issuing more debt, paying dividends, or getting into very risky business projects. When one of the restrictive criteria is broken, the lender may recall the loan or require some action, such as the assignment of extra collateral.

DERIVATIVE INSTRUMENTS
Credit risk can also be addressed through the use of derivative products. For example, credit default swaps are typically employed when corporations seek to protect themselves against the risk of a drop in value of a debt security or index of debt securities.

Lending to governments or state-owned firms raises another sort of credit risk. Sovereign risk is the risk that a government will not return its debt because it does not have either the ability or the motivation to do so. The distinctive characteristic of sovereign risk is that lenders have limited legal remedies available to compel the borrower to repay or to be able to retrieve the assets themselves. A government can also restrict borrowers in its country from repaying their loans to foreign investors — for example, by instituting currency controls to make it difficult or impossible for money to leave the country.

Liquidity Risk
As noted previously, liquidity refers to the capacity to purchase and sell fast without incurring a loss. It is a basic worry for organizations and is often disregarded when sources of financing, such as bank loans, are plentiful.

But during the global financial crisis of 2008, an acute shortage of liquidity in the banking institutions in several nations led to failures. These failures happened because some companies were unable to maintain access to sufficient money to fund their working capital (inventories and receivables from customers net of payables from suppliers) and, thus, to keep their companies functioning.

Firms in the investing industry suffer a greater level of liquidity risk than, for example, manufacturers. To function profitably, they need marketplaces that can handle their trades without large unfavorable effects on prices. 

When markets are illiquid — either temporarily, such as during financial crises, or more structurally, such as in some emerging markets — the capacity to trade assets is severely limited, which has a detrimental effect for these firms.

​Investment - Operational Risk

Operational risk is the risk of losses from inadequate or failed personnel, systems, and internal rules and procedures as well as from external events that are outside the control of the organization but that affect its operations.

Managing People
Human failures range from unintentional errors to fraudulent behaviors. Many firms are subject to occupational fraud (also termed internal fraud or employee fraud), which is when an employee abuses their position for personal benefit by misappropriating the company’s assets or resources. In a poll carried out by the Association for Certified Fraud Examiners (ACFE), anti-fraud professionals calculated that globally organizations lose, on average, 5% of their yearly revenues to fraud.

One example of operational risk that includes a human component and is more frequent in the financial services business than in any other industry is rogue trading. 

Rogue trading refers to circumstances in which traders bypass management controls and place unauthorized deals, at times creating huge losses for the companies they work for. Rogue trading may involve fraudulent trading done for personal enrichment or to make up losses.

Example: Libor Manipulation Scandal


One of the most comprehensive criminal investigations and prosecutions that arose in the wake of the 2008 financial crisis was a premeditated attempt by numerous banks and certain employees to manipulate the London Interbank Offered Rate known as Libor. At that time, Libor was the worldwide accepted benchmark rate used by banks to establish interest rates on a myriad of loans (consumer and financial) and depended on self-reported estimates of borrowing costs from banks.

Prosecutors in many jurisdictions determined that banks had collaborated by pushing their estimations higher or lower in a bid to profit from connected assets tied to the rate. In the end, many banks across the world would plead guilty and were fined billions, while scores of individuals were pursued and charged with criminal activity.  

Mitigating Risk
Banks, like other corporations, have tried to learn from past disasters and plug the holes in its systems and controls to prevent similar catastrophes from recurring. The bankruptcy of Barings Bank in 1995 exposed the consequences of not segregating front- and back-office activities appropriately.

In the modest bank branch of Barings in Singapore, the same staff managed both types of business. An initial trading loss (a front-office activity) due of a human error was hidden in the accounting system (a back-office activity), and subsequent losses mounted until they surpassed the bank’s equity capital. Following Barings’ failure, banks were compelled to establish a clear division between their front and back offices.

Companies can decrease operational risks through education by clearly conveying rules and processes and by establishing efficient and effective internal controls. Good human resource management techniques are also crucial; employing the right people and motivating them with the right incentives are well-known factors for success.


To reduce the risk of recruiting the incorrect personnel, companies often take numerous safeguards, such as the following: 
Conducting background checks, such as verifying criminal records and disciplinary records with regulators for new employment
Verifying qualifications and past work experience 
Performing personality assessment tests 
Getting character references to establish suitability

Although these safeguards may appear to be conventional, research have revealed that inconsistencies between presented and actual qualifications are prevalent. Cases in which background checks of senior executives were not correctly done are often reported. Because of a loss of trust, some of these executives had to resign when the truth was known, even if they had performed satisfactorily in their jobs. 

Risk taking should also be addressed in the structure of compensation, for example when setting bonus payments for employees. It is particularly critical for employees who expose the organization to large risks, such as traders and investment professionals. A fair compensation system should take into account the level of risk incurred for a given level of return and should reward those who accomplish returns without incurring excessive risks.


An example of an incentive that could lead to deviant behaviour is rewarding traders for earnings regardless of the risks they take. This technique would provide them all the upside for trading gains, but less downside for taking on risks and for trading losses. In actuality, traders creating big losses frequently lose their jobs and reputations, although they usually do not have to pay back much compared with the income they previously earned.

Some authorities are already implementing new compensation systems that incorporate deferred remuneration to take into consideration long-term performance as well as claw-back provisions, wherein employees may have to refund their bonuses if claimed profitable transactions result in losses later. 

Managing Systems
Companies rely substantially on information technology (IT) systems. Consequently, technology has become an increasingly major source of operational risk. Automated processes can lessen the incidence and severity of operational failures, but they are not flawless. Failures of IT and communication systems can paralyse business activities or severely diminish their efficiency, affecting the company’s profitability via reduced revenues, higher costs, or a combination of both.

IT networks are inherently vulnerable to disturbances and outside intervention owing to technical limits and human factors. One source of danger is the attitude of employees who do not follow corporate policies and, for instance, download illegal software for personal or professional use. 

The disadvantages of this technique include harmful viruses and unauthorized, and perhaps incompatible, software infiltrating enterprise systems. In addition, IT departments are in a constant war with hackers who exploit holes to enter systems.

Key controls to secure systems and corporate information include the following:
Establishing and disseminating internal policies for users and IT technical staff Creating acceptable security standards and configurations for systems
Allocating appropriate manpower and technical resources to ensure a well-controlled IT environment 

The security of secret information is also vital in the investment industry. Data privacy has lately gained in popularity due to a series of situations in which companies and government agencies allowed people’s private information to enter the public domain, exposing them to the danger of fraud.

A corporation should understand how data are produced and flow internally, classify the information by sensitivity, estimate the risks of data loss, and adopt suitable preventative measures. Many countries have strict laws and regulations for securing customer data, coupled with significant consequences for breaking these laws and regulations. 

Complying with Internal Policies and Procedures


The structure of a company varies with size and the business activities it is engaged in, but there are aspects common to all firms. For example, power and authority are delegated and duties assigned within most corporations. In smaller entrepreneurial organizations, such assignments may be communicated informally, with individuals recognizing their respective positions and degrees of authority.

In larger and more complicated firms, the responsibilities and degrees of authority will be explicitly defined and the business processes written out in more detail, frequently contained in corporate management systems. Policies and procedures should expressly set out the delegation of authority and identify clear roles and accountability. These definitions constitute the basis for the monitoring of and control of business operations and provide feedback mechanisms.


The division of duties is a fundamental notion that international firms and regulators, along with other authorities in many nations, need and urge. As discussed before, a clear distinction needs to exist between front and back offices. In accounting departments, there should also be a clear separation between those who enter items into the accounts and those who reconcile the bank statements with the cash balances in the accounting system.



This separation of roles decreases the chance that personnel who possess cash may commit fraud or pilfer funds. Compliance and internal audit responsibilities are crucial to verifying that staff are truly following internal policies and procedures.

Managing the Business Environment
The sort of environment in which a company operates might add levels of uncertainty that need to be addressed.

Political risk is the risk that a change in the dominant political party of a country would lead to changes in policies that can affect anything from monetary policy (money supply, interest rates, and credit) and fiscal policy (taxation) to investment incentives, public projects, and procurement. 

Some industries are significantly controlled by governments that, for example, regulate natural resources or set pricing of raw material inputs or outputs. In some circumstances, a change in administration or policy can impact the value of an investment. Political risk is inherent in all countries and should always be considered, even if it is deemed to be relatively remote.

Legal risk is the chance that an external party would sue the company for breach of contract or other infractions. A corporation should assess how it identifies and conforms to the legal responsibilities it has undertaken

The function of an in-house legal professional is vital to controlling legal risk. Most sections of a corporation have relations with external parties, such as deal counterparties, business partners, suppliers, and service providers. An key control in managing the legal risk of these external ties is to have legal professionals analyze every contract. 

Companies should explicitly allocate authority and indicate who should evaluate and approve certain type of contracts. The most major deals normally require clearance at the level of the board of directors. Another solution is to use template agreements and standard contract terms and conditions that have been examined and approved by the legal staff.

The preservation of records, documents, and other forms of communication must also be in conformity with legal standards for all relevant jurisdictions.

Settlement risk (or counterparty risk) is the danger that while closing a transaction, a corporation fulfills one side of the contract, such as sending a security or money, but the counterparty does not complete its side of the deal as agreed, frequently because it has declared bankruptcy. This risk is sometimes also called Herstatt risk because of an incident in 1974 when the German Herstatt Bank ceased operations after counterparties had honoured their obligation to transfer Deutsche Marks to Herstatt, but before Herstatt honoured its obligation to transfer the equivalent amount in US dollars back to these counterparties.


Although there are usually legal procedures to compel a counterparty to meet its obligations, such actions are costly and time consuming. A counterparty is more likely to find it difficult to fulfil its obligations during adverse economic times or when bankruptcy is imminent than during successful periods. In the case of bankruptcy, it may take months or years to receive assets through a bankruptcy resolution procedure and the proceeds may only be a fraction of the original nominal amount of debt.


It is vital to identify the risks inherent in bilateral arrangements from those in transactions contracted through central counterparties, such as clearing institutions. Clearing houses may step in to accept the risk of a counterparty failing to meet its contractual obligations. Other measures to mitigate this risk are margin requirements or standardised agreements.

​Investment - The Performance Evaluation Process
Performance Evaluation
Investors are interested in knowing how their investments have performed. For retail investors, the success of their investments may determine whether they will experience a happy retirement, if they will have enough money to send their children to university, or whether they can finance their ideal getaway. Likewise, pension plans, foundations, and other institutional investors want to monitor the performance of their investments to guarantee that the assets will be sufficient to meet their spending needs.

The performance of a fund is also crucial to an investing firm. Measuring and analyzing fund performance is crucial to controlling and enhancing the investing process. 

But knowing the return achieved by a fund is only half of the process of performance review. Investment management is a competitive industry. 

Both investors and investment businesses will want to know how funds have done relative to key financial market benchmarks (e.g., a stock index like the S&P 500 Index in the United States or the Hang Seng Index in Hong Kong) and comparing to their peers.

" " In addition, interested parties will want to know how the fund manager accomplished the performance – for example, if the performance was the consequence of talent or luck, or possibly even excessive risk-taking.

It is only via the rigorous evaluation of investment performance that investors and investment firms can make informed judgments about their investments. After reviewing a fund’s performance, investors can decide whether they wish to continue to invest in the fund or sell all or part of their investment in the fund. Similarly, an investment firm can analyze the fund’s performance to see whether the fund is performing as predicted given its strategy and market conditions or whether changes need to be made to the investment process. 

The performance evaluation process contains four discrete, but connected, components:  
measure absolute returns
measure relative returns 
alter returns for risk 
attribute performance