Setting Investment Parameters
Overview
The first step of the asset allocation process is often to set the parameters within which the fund will
operate.
Investment Horizon
Investment horizon is a critical parameter to understand and is usually tied to the purpose of the fund.
Some funds are designed for the purpose of providing for an ongoing concern such as a company or extended family.
In such a case, the fund may not have a set horizon or is considered long term in nature.
In other cases, a fund is established to provide for an upcoming purpose, such as a car or house, or
for a future retirement. In any case, understanding the number of years under consideration is a critical
component to determining how to manage the fund.
Risk Tolerance
Risk tolerance is a constraint provided by the client of the fund. It specifies the clients ability to weather downturns
in the funds asset value.
Risk tolerance can be stated in terms of a set of measurements such as
- Portfolio Volatitilty
- Maximum Drawdown
When stated in terms of risk measure as above, the tolerance measure is typically a max target that can
be violated on only rare occasions. (For example, guaranteeing that a fund will not exceed a certain measured
risk tolerance cannot be made with perfect certainty.)
Portfolio Constraints
Portfolio constraints refers to constraints placed on the portfolio by the client. Typically these constraints are
designed to limit the types of the risks that the portfolio is allowed to invest in, mostly due to the
comfort level of the client. As an example, some clients will limit their funds to be long only (no short sales)
or they bar the fund from investing in derivatives.
Portfolio constraints are constraints that can be guaranteed with certainty, as opposed to the risk measures listed above.
