14. Managing Portfolios: The Practice Flashcards
Describe the nine-step model for investment advising.
(1) Understand the client’s goals
(2) Identify a target rate of return
(3) Agree on the time horizon
(4) Understand the client’s tolerance for and capacity for risk
(5) Define the asset classes
(6) Determine an appropriate asset allocation
(7) Create the Investment Policy Statement (IPS)
(8) Select the investments themselves
(9) Monitor and adjust as needed
Describe the differences between strategic and tactical asset allocation.
Strategic asset allocation decisions should be made at the highest level of an organization,
are rarely changed, may be in ranges rather than point estimates, and are made to set
the overall risk exposure and liquidity desired. Tactical asset allocation decisions must
be made at lower levels, may be changed frequently, are usually point estimates, and
are made to attempt to beat the market.
Why is it difficult to specify the optimal number of securities in a portfolio?
Simply specifying the optimal number of securities in a portfolio is problematical because such rules
(1) assume the holdings are evenly distributed, which even if they were, would not remain the case for long;
(2) overlook the extent to which the stocks in the portfolio are from the same industry, or otherwise closely related in their covariability;
(3) some assets,such as mutual funds and ETFs, already contain a tremendous degree of diversification;
(4) other assets, such as foreign holdings, are much more efficient at diversification than domestic holdings;
(5) because this number depends on the trade-off between the transaction costs and indirect (monitoring) costs of adding a security to the portfolio and the perceived magnitude of the reduction in total risk.
What are the two key issues associated with the rebalancing process?
The two key issues are how frequently to rebalance, and to what point should one
rebalance. The frequency refers to whether to do it daily weekly, monthly, quarterly,
semiannually, or annually. The extent of rebalancing refers to whether one should
rebalance to the closest end of the acceptable range, the midpoint of the acceptable
range, or someplace in between. The answer depends in part on the cost of rebalancing
Why would having multiple accounts with different tax treatments create a
potential problem in matching a strategic asset-allocation scheme?
For optimal tax efficiency, the traditional rule is that debt instruments should be held in tax-exempt or tax-deferred accounts, and equities in taxable accounts. However, the amounts in these accounts may not match the asset allocation scheme. In addition, as market values change, if the investor wanted to buy more bonds, he or she might not be able to add the necessary cash to a tax-qualified account. Hence, the investor would end up holding bonds in a taxable account, or failing to meet his or her target asset allocation scheme.
. Why is the expected return on socially responsible portfolios not expected to
differ from the expected return on other portfolios of equal riskiness?
Because not everyone objects to the same types of stocks, as long as enough people are
willing to hold any one stock, its expected return will be consistent with its risk.
Describe how to set up a collar to protect a client with a concentrated portfolio
and give an example.
A collar involves writing call options whose strike prices are above the current market
price, and using the proceeds to buy put options whose strike prices are below the current
market price. For example, suppose the concentrated holding trades at $52 per share,
and the options are available with strike prices of $50 and $55. Write call options at $55,
and use the proceeds to buy put options at $50.
Over the next three months, you will be transferring $100 from your
end-of-month paycheck to the XYZ fund, for the immediate purchase of
shares. What is the total number of shares purchased and the average cost
per share if at the time of purchase the NAV of the fund (assume it is a
no-load fund) has the following values: $10, $5, and $15.
The value of your portfolio is determined as follows:
P = $10, buy 10 shares; total shares = 10; Portfolio = 10 x $10 = $100
P = $5, buy 20 shares; total shares = 30; Portfolio = 30 x $5 = $150
P = $15, buy 6.67 shares; total shares = 36.67; Portfolio = 16.67 x $15 = $250
P = $10, buy 10 shares, total shares = 46.67; Portfolio = 46.67 x $10 = $466.70
Average cost per share = $400/46.67 = $8.57
List some examples of dollar-cost averaging plans.
Examples of dollar cost averaging plans include dividend reinvestment plans
(DRIPs), direct purchase plans (DPPs), and employee stock purchase plans
(ESPPs).
You show a client the two results from flipping a coin six times. The first result
is H, T, T, H, H, T. The second is H, H, H, T, T, T. You ask the client which result
is more likely to have actually occurred. The answer is that they are equally
likely, but the client is almost certain to say the first is more likely. Why?
People look for patterns, and when they see them assume some sort of causality.
Because the second series has two series of 3 consecutive outcomes, the average person will assume something was causing the outcome to repeat. In truth, the probability of any sequence of heads and tails occurring when a coin is flipped 6 times is (1/2)6 = .0156.
Give an example of how a plan could be pitched to a client without using the
terms asset allocation, expected return, and standard deviation of return.
Refer to any of the examples used in the text, wherein the client and planner determine
the amount sufficient in cash and/or bonds to assure the client that the cash will be
available to meet his or her needs for a specific number of years.
The first step of the nine-step investment process is to understand the client’s goals.
True
The more general the statement of goals, the better the planning process.
False. Goals should be as precise as possible, and they should include dollar objectives if possible. Otherwise, the planner does not know what rate of return needs to be achieved.
The client’s risk tolerance is always a critical constraint.
True
If the client’s degree of risk aversion can be well measured, then it is clear what the asset allocation of the portfolio should be.
False. There is no theory or obvious scale for relating risk aversion to asset allocation.
A financial planner cannot gauge a client’s tolerance of risk by simply looking at things like whether the client gambles or drives recklessly because risk aversion is not a generalizable characteristic.
True
