Diversifying the Investment Portfolio

Government investors have a fiduciary responsibility to protect public funds and to prudently manage their investments in order to achieve the investment objectives of safety, liquidity, and return. Generally, greater risk in a portfolio increases the opportunity for higher returns. However, greater risk also increases the volatility of the returns, which is another definition of risk. The effective management of risk in a portfolio is critical for achieving an entity's investment objectives.

A useful strategy for managing risk in a portfolio is through diversification. To this end, a government should establish a target risk profile. In establishing a risk profile, an entity considers its investment objectives and constraints, risk tolerances, liquidity requirements and the current risk/reward characteristics of the market. The profile should be adjusted as needed to changes in any of those considerations. Such a profile provides a framework and discipline for making individual investment decisions that manage the risk and create the structure of a portfolio.

The government entity's risk profile, in turn, helps it determine appropriate levels of diversification. Diversification of investments in a portfolio is based on the different types of risk - primarily interest rate or market risk, liquidity risk and credit risk. Diversification is achieved by investing in a variety of securities with dissimilar risk characteristics that respond differently to changes in the market. Areas where diversification can be achieved include the maturity distribution in a portfolio (market and liquidity risk), sector allocation (credit risk), issuer allocation (credit risk), and the structures (noncallable vs. callable) of securities (market and liquidity risk).

• carefully and clearly defining what the objectives safety, liquidity and return mean to the government entity
• preparing a cash flow projection to determine liquidity needs and the level and distribution of risk that is appropriate for the portfolio
• considering political climate, stakeholders' view toward risk, and risk tolerances
• ensuring liquidity to meet ongoing obligations by investing a portion of the portfolio in readily available funds, such as Local Government Investment Pools (LGIPs), money market funds, or overnight repurchase agreements
• establishing limits on positions in specific securities to protect against default risk
• establishing limits on specific business sectors
• developing strategies and guidelines for investments in single class of securities (such as commercial paper or bankers acceptances)
• limiting investments in securities that have higher credit and/or market risks (such as derivatives)
• limiting particular structures (i.e. optionality, amortizing components, coupons, issue sizes)
• defining parameters for maturity/duration ranges
• establishing a targeted risk profile for the portfolio based on investment objectives and constraints, risk tolerances, liquidity requirements and the current risk/reward characteristics of the market.