1) How much capital has been saved?

2) How much investment income will the savings or capital generate?

3) How much income does the retiree require in order to live comfortably?

Why should an individual save? There are a number of reasons why individuals should save on their own, without relying exclusively on government or employer-sponsored pension plans.

• To increase future consumption.
• To maintain current consumption if earnings fall.
• To stabilize consumption over a lifetime.
• To preserve a reasonable lifestyle.
• To build an estate for heirs.

Savings consist of spreading consumption over time; and they result from the postponement of current consumption in order to be able to fund future consumption. Consumption at some point in the future is determined by future savings, current savings already accumulated, and the investment return on the current savings (including the effects of income tax). Savings increase future purchasing power only if the real return on savings is positive, i.e. greater than the rate of inflation. Current savings, which are also called asset reserves, would include forced savings such as the Canada Pension Plan (CPP) and employer sponsored registered pension plans (RPPs). These types of forced savings plans affect the level of voluntary savings, but they will eventually contribute to future consumption.

The purpose of an investment policy is to outline or provide a basis for an asset allocation mix that is suitable to the investor's goals, constraints, and risk tolerance. An investment policy establishes objectives along with the approach that is to be used to obtain them. The benefit of a written investment policy statement is to maximize the investor's well being and net worth while considering the financial objectives and any specific constraints that are imposed by the investor.

An investment policy must be formulated and based upon the specific circumstances and characteristics of each investor. These situation specific characteristics include:

• age,
• investment risk tolerance,
• capital currently available to invest,
• current income,
• the future need for investment capital and income, and
• the amount that is required to be saved on an ongoing basis.

The investment policy must take into account inflation, economic growth, and the investor's investment time horizon.

Additionally, an investment policy must consider the investor's consumption or desired consumption profile, which is influenced by five factors:

• Initial savings or wealth.
• Periodic income.
• Periodic savings.
• Real return generated on the portfolio.
• Consumption preferences i.e. the importance to the individual of trading off current consumption for the ability to consume in the future.

Typical investment objectives that must be considered and formulated into an investor's investment policy and asset allocation decisions include:

• Preservation of capital.
• Requirement for current investment income.
• Capital growth.
• Minimization of income taxes.
• Liquidity of the investment.

In order to formulate a portfolio management strategy, it is important to understand some basic information such as what an investment is.

An investment is defined as any asset into which funds can be placed with the expectation that the invested capital will generate additional positive income; and many investors, will insist that, as a minimum requirement, the investment will preserve its value.

Many types of investments are available; ranging from those which will protect and retain capital, to the more aggressive derivative securities. Investors select investments to meet personal income goals and requirements, including interest income, capital growth, dividend income, and rental income.

Today, investors search beyond local markets for higher returns and foreign market diversification opportunities. Diversification plays an important role in lowering risk through the development of a portfolio that includes a number of different asset classes.

There are four steps in investment portfolio management:

1) Identify investment objectives, preferences, and constraints and determine the resulting investment policy that is then documented.

2) Determine and apply an investment strategy through the choice of specific financial and real assets, using the guidance of the investment policy statement.

3) Monitor changes in market conditions and the circumstances of the specific investor.

4) Adjust the portfolio to take into account any changes that occur.

Asset allocation is an important part of portfolio management. Asset allocation is the decision making process relating to the determination of:

• which asset classes are to be considered for inclusion in the investment portfolio,
• the proportion of funds which are to be allocated to each asset class, and
• the determination of how much money is to be invested into each security within individual asset classes.

There are three steps in the asset allocation process, which are undertaken by asset managers:

1) Determine the financial and investment objectives.

Investment strategy will differ according to the various personal objectives of investors. When the investor is seeking to maximize the total return on a portfolio, research has shown that it is more important to choose the right asset mix rather than the right investment within the asset class.

2) Identify the investment constraints that are specific to the individual investor.

Factors to be considered here are personal data such as:

• age,
• family obligations,
• income tax considerations,
• net worth,
• current income,
• investment personality, knowledge, temperament, risk tolerance, unacceptable risks,
• time horizon, and
• any other relevant investment constraints.

3) Determine the allocation strategy.

This step involves choosing a risk and reward combination which provides the highest levels of investor utility or satisfaction with which to achieve the financial objectives, while considering an investor's specific constraints and personal circumstances.

However, before developing an investment strategy it is necessary to determine whether or not the goals and objectives are realistic. It is important to comprehend all of the risks that are specific to each of the various components of the portfolio. This is critical in order to understand the relationship that exists between risk and the investment time horizon. It is also necessary to consider the benefits of a diversified portfolio.

Diversification is a critical aspect of portfolio management, which can be achieved through asset allocation. An asset allocation program can:

• Diversify by asset class, which is usually expressed as a range of recommended percentages with a specified minimum and maximum limit.
• Diversify within asset classes.
• Diversify geographically.
• Review and re-balance the portfolio.

Diversification is a risk management technique that attempts to provide some insurance against the unexpected. The rule of thumb for diversification is to combine investments that have low or negative correlations, in order to eliminate specific and unique investment risk in a portfolio, until only market risk remains. When only market risk remains in a portfolio, options and futures derivative contracts can be used to hedge these risks.

Diversification also has an effect upon portfolio return; it reduces risk but it can also reduce a portfolio's maximum return. Diversification lessens the pressure to sell a particular holding and therefore, increases trading flexibility by extending the investor's time horizon.

Using a strategic approach to portfolio management, there are potentially three levels of diversification within an asset allocation model, and an investor should determine the answers to the following questions:

For many investors, risk is generally considered to be related to bad news. What many individuals fail to realize is that all investment entails risk, and that any investor who wishes to obtain a return that is higher than the risk free rate must assume investment risk.

Modern portfolio theory assumes that investors are rational beings who are risk averse and that given equal returns, will prefer an investment that has the lower risk. If two investments have equal risk, a rational investor will prefer the investment with a higher return. Investors are not as averse to risk as they are averse to losses.

A forecast of a security's return is an expected or anticipated value which is representative of the investor's expectations of the return distribution for the security, and the expected return includes both the expected realized and unrealized annual income. Historic returns are not good predictors of future returns.

The expected return of a portfolio is the weighted average of the expected returns of the securities that comprise it. However, the risk of a portfolio is a function of three factors:

• the relative weights of each of the assets which comprise the portfolio,
• the volatility of each of the portfolio's components as measured by the standard deviation of returns, and
• the correlation of the returns between each pair of assets which comprise the portfolio.

Analysts and academics use several tools to facilitate the evaluation of portfolios, one being the normality assumption. The normality assumption indicates that the returns on a security are clustered around a single number. Statisticians call this the central tendency towards the mean or average. This normality assumption allows an investor or portfolio manager to make selections of securities based on only two criteria: the expected return of the security, and the standard deviation of the security's return.

Standard deviation is a measure of the expected deviation or variability of returns in relation to the expected return. Standard deviation is a statistical measure of the spread of the security's returns. As a general rule, the higher the standard deviation, the higher the total risk of a security or a portfolio.

The standard deviation of a portfolio is always less than or equal to the weighted average of the standard deviations of the component securities.

The standard deviation of a portfolio can be calculated from the standard deviations of the individual securities that make up the portfolio. Even if the return distributions of the individual securities within a portfolio are not normally distributed, as the total number of securities held in the portfolio increases, the distribution of the portfolio's return tends towards normality.

The standard deviation associated with the return on an asset decreases with the square root of time. Therefore, the longer the analysis horizon is, the lower the standard deviation of the annualized returns over the horizon will be. Extending the time horizon decreases the risk of a stock investment in relation to a riskless asset. A minor forecasting mistake can have an important impact on the final portfolio value if the analysis horizon is long. For example, assume that investment has an expected annual return of 10% with a standard deviation of ± 20%. This means that the return on the investment can vary from -10% to 30% in any given year. However, if the investment is held for 10 years, the standard deviation drops to ± 6.32%; after 25 years, the standard deviation is ± 4.0%; and after 45 years, the standard deviation drops to ± 3.98%.

= standard deviation of average return over n years

= standard deviation of rate of return in 1 year

n = time in years

Another important measure used in portfolio analysis is correlation. Correlation describes how well two assets move relative to one another. The correlation coefficient describes the pattern of two asset's returns relative to one another. A correlation coefficient can range between -1.0 and + 1.0. Assets are said to be perfectly positively correlated if the correlation coefficient equals 1.0 and the assets are said to be perfectly negatively correlated, if the correlation coefficient is -1.0. A correlation coefficient of 0.0 indicates that the returns of two assets are uncorrelated. In portfolio management, the intent is to locate and combine assets with low or negative correlations. For diversification purposes, a perfectly negative correlation is most attractive, since this indicates that the securities vary in opposite directions and fluctuations will tend to cancel one other. Correlation of -1.0 (perfect negative correlation) allows the risk of the portfolio as measured by the standard deviation to equal zero.

In the real investment world, there are no assets with perfectly negative correlation. However, one of the major reasons cited for the inclusion of foreign equities in a balanced portfolio, is the negative correlation between North American and other stock markets. Furthermore, research also indicates that there is a negative correlation between equity markets and commercial real estate.

There is no unique, riskless asset, since all investments carry a risk of some type. However, by convention or proxy, federal government securities are considered risk free. For many years T-bills were considered the appropriate risk free investment against which to measure investment performance. However, the more sophisticated analysis that is supported by modern portfolio theory suggests that better investment decisions can be reached when one assumes that there is one riskless asset for each selected investment horizon. For example, an investor with a 20 year time horizon would use a twenty year government of Canada bond as the appropriate risk free asset against which to measure portfolio returns.

The following concepts and techniques assist in gaining a better understanding of an individual's perceptions of investment risk as a whole, which can be used when determining the individual components that will eventually comprise a portfolio.

1. Demographics.

• Men will usually accept higher risks than women will.
• Risk tolerance decreases with age.
• Risk tolerance increases with wealth, income, and education.

2. Life-cycle approach.

• The accumulation phase is represented by a young person just starting out in a career. Priorities are usually to build up some savings, obtain life insurance, buy a home, and start a family. With a long investment time horizon, large risks can, theoretically, be taken.
• In the middle years, an individual is in a position to start a serious savings program. Discretionary income is generally high and typically, a primary goal is retirement saving. The time horizon is generally still long, although income tax considerations are probably more important than in the accumulation phase. There is usually little need for current income, and the appropriate investment policy is generally one of real growth.
• At the time of retirement, there is usually a need for stable income and risk tolerance diminishes. Inflation protection may be desirable, and typically, the need for investment marketability is higher than in the other life-cycle stages.

3. Investment personality or psychographics.

• Passive investors are inclined to be people who have acquired wealth passively for example by inheritance. Generally, these individuals have low-risk tolerance. Passive investors tend to be risk adverse trend followers, who prefer a well-diversified portfolio. Academic research shows that a large percentage of low and middle income families tend to produce passive investors.
• Active investors on the other hand, tend to have a higher risk tolerance. These individuals typically, want to take control of their financial destiny. Active investors tend to be individuals who have earned their own wealth for example, entrepreneurs. Active investors typically follow a focused rather than a diversified investment policy. As well, active investors often have been raised in middle to upper income families.

In managing a portfolio of investments, an investor will undertake changes in the portfolio from time to time due to a:

• Change in the specific circumstances of an individual investor.
• Change in the expected return of an asset.
• Change in the risk of an asset.
• Change in the correlation between two assets.
• Change in the risk free rate of return.
• Change in general economic conditions.

The rebalancing of a portfolio involves both time, and transaction costs. Therefore, portfolios should be reviewed regularly for changes in material events in the individual investor's personal circumstances; and the relative appeal of the various portfolio components as market conditions evolve. Typically, asset mix decisions are made for one year at a time.

Two of the most commonly referred to asset allocation techniques are strategic and tactical asset allocation.

• Strategic asset allocation is based on data covering the clients investment horizon and dictates which asset groups should be emphasized or underweighted in the portfolio. The higher that an individual's aversion to risk is, the smaller the allowed deviations from the strategic allocation should be.
• Tactical asset allocation involves temporarily departing from the strategic weighting's in order to benefit from temporary imbalances in the securities markets.

The success of the portfolio manager is measured by comparing the total return of the portfolio to comparable benchmark portfolios. The most common calculation is based upon total return divided by the average amount invested.

In order to create a portfolio of assets, it is imperative that individuals acquire knowledge of some of the basics of investment theory. These include stock and bond valuation techniques, factors which affect and cause price movements of individual investments, industry life cycles and other criteria in the investment environment which affect investment performance and therefore will impact the final investment decisions.

Investor expectations concerning interest rate movements and future inflation often guide investment purchase decisions. Expectations of future inflation rates are built into the interest rates and for example, fixed-rate bonds offer no protection against unanticipated and sustained periods of high inflation. Conversely, a variable-rate bond may offer some inflation protection. Investor expectations of the future earnings and dividend payments of a common stock determine the market value, although the value of assets is also an important factor. A great company in a growth industry however, can still perform poorly if the company disappoints the consensus of analysts' earnings estimates. Large transactions may affect prices temporarily creating bid-ask imbalances. Stock prices can also be affected by rumours, or by public tender offers.

Many tools exist that can be used to value equity securities. It is recommended that some form of analysis be performed before purchasing a corporation's stock. Company performance analysis usually includes a review of the historic trends. Although past performance is no indication of future performance, a reasonable assumption is that things will continue as they have in the past.

Fundamental analysis is the evaluation of a company based on its historic financial statements combined with an analysis of the company's future prospects.

Trend analysis would review historic sales, profits and debt levels. Trend analysis would also review valuation ratios such as the price earnings ratio (P/E), price to book value, book value per share, and price to sales.

Other corporate factors that is valuable when analysing company performance include the product line, product quality, human resource needs, training, and the technological state of machinery or equipment.

The valuation tools used most frequently by investors and analysts include:

1. The dividend discount model (DDM). This is a method for calculating the market price of a blue-chip company's common shares. The value of a common stock is the present value of all future dividend payments.

2. The price to earnings (P/E) ratio is calculated as the price of the common share divided by earnings per common share. A company with higher quality earnings should have a higher P/E ratio than a company with low quality earnings. A growth company will have a higher P/E ratio than a stable company. The P/E ratio for a company should be compared to other companies in the same industry. It is important to note that the P/E ratio is the inverse of market interest rates and when consumer confidence is high, P/E ratios will tend to be high.

3. Growth is not always a blessing. Without careful financial planning, growth can cause cash flow problems. A company's sustainable growth rate is the maximum rate at which it can grow without straining its financial resources. The long-term sustainable growth rate (g) is calculated as the product of the return on equity (ROE) and the company's earnings retention rate (RR). If the actual growth rate exceeds the sustainable growth rate, the company must eventually raise additional capital. To raise capital internally, a company can sell equity, increase financial leverage by issuing bonds, reduce dividends, sell marginal operations, outsource production or administration, or increase prices. Externally, a company can seek a merger partner or acquirer.

4. One powerful analytical tool to analyse a company's return on equity (ROE) is the DuPont method of analysis. There are a number of variations of the DuPont analytical technique, which break down the relationship between net income and shareholders equity. One method of ROE analysis uses 3 components that show the relationship of the firm's net profit margin, total asset turnover, and financial leverage. Another, more sophisticated method of ROE analysis uses 5 components that show the interaction of the operating profit margin, total asset turnover, interest expense rate, financial leverage multiplier and tax retention rate. These various components help to analyse the efficiency of a corporation's competitive situation, internal operations, the use of financial leverage, and the impact of the government tax policies.

The price of a bond is based on its coupon, maturity and prevailing market interest rates. Bond price volatility depends upon the cash coupon and the time remaining until the bonds maturity.

The market value of a bond equals the present value of all future cash flows accruing to the investor. Cash flows for the conservative bond investor include periodic interest payments and principal return. Cash flows for the aggressive bond trader may include periodic interest payments and the capital gained or lost when the bond is sold before its maturity.

Any investor contemplating the inclusion of bonds into a portfolio requires an understanding of how and when bond prices change in the marketplace. The coupon rate of the issue, the features of the issue, the credit rating of the issuer and, the term to maturity can affect the bond's market price. The current level of interest rates determines bond prices in the secondary market. When interest rates rise, bond prices fall, on the other hand, when interest rates fall, bond prices rise. A bond's price therefore is said to vary inversely with market interest rates.

A bond with a high coupon rate will trade at a higher price and with less volatility than will a similar bond with a low coupon rate. The greater the portion of the yield that the investor receives through coupon payments (cash income) rather than through the value of the bond at maturity (capital gain), the smaller the risk and therefore, the higher and more stable, a bond's price. In other words, cash flow has value. Cash flow cushions the variability in price movement of the bond. Therefore, high coupon bonds are sometimes known as cushion bonds.

Features of a debt issue include convertibility, call provisions, sinking funds, and purchase funds, any and all of which can affect the market price of the bond. The higher the credit rating of the issuer, the higher the price of the bond, everything else equal. The closer a bond is to the maturity date, the smaller will be the variation from the par value of the bond.

During periods of rising interest rates, the prices of longer-term bonds usually decline more than the prices of shorter term bonds. When interest rates fall, however, prices of longer term bonds tend to rise the most. Longer term bonds are, therefore, more volatile than short term bonds. Lower coupon bonds are more volatile than high coupon bonds. Bond prices, in general, are more volatile when market interest rates are low.

The market price of a fixed income bond depends on its coupon, maturity date and the prevailing market interest rate. Prices decline when interest rates rise and bond prices rise when interest rates decline in order to adjust the price and to reflect a competitive yield. A change in the issuer's credit rating can also cause a fluctuation in price, as higher risk is reflected in the price/yield relationship. Even without a formal rating change, reduced demand can cause lower bond prices and higher yields. For example, this is rapidly reflected in the price of junk bonds when market participants fear that a recession will lead to an increase in defaults. Poor business conditions over a prolonged period can cause financial weakness and jeopardize the firm's ability to pay interest.

Purchasing a bond when interest rates are high is preferable, because the highest yields can be locked in for the long-term. Holding bonds is most attractive when rates are declining, due to the upward movement in the market prices of fixed income securities. High inflation erodes the dollar value of fixed interest payments. Falling interest rate periods are boom times for bondholders.

Bond prices are quoted in daily newspapers and are easily available over the Internet.

The profitability of an industry tends to be a function of the competitive structure within the industry. The competitive structure, the amount, and the intensity of the competition within the industry are important because these factors determine the prices, costs, advertising, and the overall investment that a firm is required to make in order to compete successfully. The competitive environment in which a company operates can have a dramatic impact on its stock price. A company's long-term survival depends upon its ability to exploit its long-term sustainable competitive advantage. There are three generic competitive strategies that are used by a corporation's management in order to accomplish the firm's strategic objectives —cost leadership, differentiation, and focus.

• Cost leadership means that a firm sets out to become the low-cost producer in its industry.
• A firm implementing a differentiation strategy seeks to be unique, and the reward for that uniqueness is a premium price.
• The focus strategy has two variations. A cost focus seeks a cost advantage in the target segment, while a differentiation focus pursues differences within a target niche.

Industry analysis is the study of industry groupings including an examination of the competitive position of a particular industry in relation to other industries. The intent is to identify companies that show particular promise within an industry. These analyses are affected by demographic and social changes. An integral part of any industry analysis will be to determine the industry's stage in its growth cycle. Additionally, it is important to bear in mind that governments can impact an industry and its future prospects through regulations, deregulation, taxes and subsidies.

Like people, industries and companies tend to go through predictable stages. Understanding where an industry is located in its life-cycle will enable the investor to make better investment decisions, since different types of valuation methods are used for companies in different stages of maturity. Additionally, the stage of the life cycle has a tremendous impact upon business risk.

1. The developmental or formative stage.

• This stage is often driven by entrepreneurial and innovative focus.
• The industry sales and earnings are usually small or possibly negative.
• Growth prospects are high.
• Competition tends to increase during the progression of this phase as other entrepreneurs recognize the market potential.
• High risks exist in this stage since there is uncertainty as to whether or not consumers will widely accept the product, and which firms will survive.
• Venture capitalists are often active during this stage.

2. The expansion or growth stage.

• This stage is characterized by rapid growth of both unit sales and profits.
• Market leaders tend to emerge due to consolidation and shakeout of weak competitors.
• Consumer acceptance broadens the market as the leaders improve the product.
• Risk in this stage declines due to increased consumer acceptance and customer loyalty starts to build.
• Companies tend to start to go public with initial public offerings (IPO).
• Companies tend to reinvest earnings therefore, little or no dividends are paid to investors, but return on equity (ROE) tends to be high.

3. The maturity stage.

• This is usually the longest stage in the life cycle and can last for many decades.
• Typically, in this stage, approximately 80% of the market has been saturated.
• The growth rate slows and stabilizes at a level that is sustainable over a long period of time, due to competition and shrinking profit margins.
• Firms tend to expand into additional market niches by developing add-ons for the original product, which helps to sustain a higher growth rate.
• As growth slows, the need to expand production facilities declines, which reduces the need for capital expenditures, improving the firm's overall financial flexibility.
• Excess cash that previously has been reinvested into expansion is now available to reduce corporate debt or to be paid as dividends to investors.

4. The declining or harvesting stage.

• The real growth rate tends to decline to a level that is less than that of the overall economy.
• Substitute products and technologies tend to make the industry's product obsolete.
• Firms tend to focus on keeping costs down, in order to maintain, or slow the decline in profit margins and profits.
• Firms may actually sell production assets that are no longer required.
• Dividends paid to investors tend to be large.
• The firms in this stage are often referred to as cash cows.
• However, it is possible for firms and industries to perpetuate themselves by becoming more dynamic and by adding new products or new product lines.

Demographic and social changes may have a dramatic influence on the outlook for an industry, or company. This, in turn, will affect investor expectations and therefore the market price of the firm's securities.

• Age distribution. The baby boom generation, which was born between 1946 in 1963, has already and will continue to have a dramatic impact on the relative fortunes of industries and firms. As baby boomers continue to grow older, they will increase the demand for health-care services, pharmaceuticals, retirement communities, and other leisure activities such as RV's, travel, and cruises.
• Income distribution. As baby boomers reach the ages of 45--54 which is typically when family incomes are at their highest, demand for luxury goods should also rise. Diversity in income distribution should lead to more niche markets. Companies that do not target but instead employ a shotgun approach to marketing may find the demand for their products shrinking.
• Distribution of the industrial mix. The shift away from the traditional Canadian resource industries and towards service and technology, which require a highly skilled workforce, can affect the future prospects of firms.

The changes in flows of exported goods and services have a dramatic impact on the Canadian domestic economy because capital flows influence both interest rates and exchange rates. An investor must be cognizant of the political and economic prospects for our major trading partners and recognize the effects these factors will have on Canadian companies.

Monetary and fiscal policy can affect domestic interest rates.

An inversion of the yield curve occurs when short-term interest rates are higher than long-term interest rates. This often signals a decline in the near future for the stock markets, as investors seeking the safety of high yielding, short-term treasury bills, abandon equities.

A decline in long-term interest rates usually results in higher stock prices since there is greater demand for stocks and less demand for long-term bonds.