Private Wealth Management Flashcards
Traditional Finance
how individuals should behave; efficient markets; utility theory with diminishing marginal returns (convex indiff curves)
REM - risk averse, rational expectations, asset integration
Behavioral Finance
how individuals actually behave and make decisions to realize lifestyle-based objectives - need to consider loss aversion, biased expectations, asset segregation
- micro = decisions of individuals
- macro = why markets deviate from TF expectations
Source of Wealth
Active: created through entrepreneurial activity; more willing to take risk
Passive: created through inheritance, windfall, saving; less willing to take risk
Measure of Wealth
how much wealth client preceives themself to have
positive correlation between preception of wealth an willingness to take investment risk
Stage of Life
- Foundation: generating wealth, long time horizon, risk: higher willingness, lower ability
- Accumulation: accumulated some wealth, long time horizon, higher risk, risk: higher willingness, higher ability
- Maintenance: retirement, lower risk, shorter time horizon
- Distribution: assets > level of need, risk depends on goals
Personality Types
- Cautious investor: risk averse, decisions based on feelings
- Methodical investor: risk averse, decisions based on facts
- Individualistic investor: less risk averse, decisions base on facts
- Spontaneous investor: less risk averse, decisions based on feelings
Client Benefits of IPS
- identify objectives and constraints
- dynamic (can change)
- easily understood, transferable
- educational about themself/ investment process
Manager Benefits of IPS
- know client
- guidance for decisions
- guidance for resolving disputes
IPS Objectives
- return
- risk
IPS Constraints
- time horizon
- taxes
- liquidity
- legal
- unique
Ability to Take Risk
ability to sustain loss without putting goals at risk
- time horizon
- goal size in relation to portfolio size
- liquidity needs
- goals that cannot be deferred
- ability to replace losses in value (portfolio = sole income)
Willingness to Take Risk
psychological profile
Return Objective
- list objectives
- determine asset base
- determine distribution
- calc [real] return (distribution/ base)
- calc nominal return (real + inflation)
Process of Elimination
eliminate asset allocation models that
- violate constraints
- violate risk objective
- fail to diversify
- don’t maximize return to risk (efficency, sharpe ratio)
Deterministic Approach
traditional approach
linear return analysis; single req return, not representative of actual volatility, no insight into risk
Monte Carlo Simulation
calc req return, each variable given prob distribution, thousands of simulations
PROS: considers path dependency, risk/ return trade offs, tax analysis, SR vs LR risk, multiple periods
CONS: GIGO
Tax Drag
money lost to taxes
tax drag$ = gainPT - gainAT
gain = FV - BV
tax drag% = TD$/ gainPT
RAE
accrual equivalent return; hypothetical tax rate if taxed every period
- RAE = (FVAT / PV)1/n - 1
- RAE = r * ( 1 - TAE )
** might not be on exam
Tax Regimes
- Progress: favorable for int, div, cap gains
- Heavy: favorable for int
- Light: favorable for div, cap gains
Accrual Taxation
taxes paid periodically
FVAT = PV [1 + r * ( 1 - t )]n
TD% > t
TD positively correlated with n and r
Capital Gains Taxation
tax on gains from sale
capital gain = sale proceeds - tax basis
FVAT = PV [( 1 + r )n ( 1 - tcg ) + tcg*B]
B = tax basis/ MV
- B < 1, unrealized gain, TD% > t
- B > 1, unrealized loss, TD% < t
Wealth Taxation
periodic tax on total value (property tax)
FVAT = PV [(1 + r) * (1 - tw)]n
- inc n = inc TD$, inc TD%
- inc r = inc TD$, dec TD%
Blended Taxation
over/ understates after tax return b/c unrealized gain/ loss
weighted avg realized tax rate (wartr) = piti +pdtd + pcgtcg
deferred cg tax rate (T*) = tcg [pdeferred cg / (1 - wartr)]
FVAT = PV [(1 + r*)n ( 1 - T* ) + T* - ( 1 - B )tcg ]
TDA
tax deferred account; contributions are pre-tax, tax on withdrawals (best for CBs)
FVAT = PV ( 1 + r )n ( 1 - tn )
TEA
tax exempt account; contributions are taxed, no tax on withdrawals
FVAT = PVAT ( 1 + r )n
TEA vs TDA
t0 < tn : prefer TEA
t0 > tn : prefer TDA
t0 = tn : indifferent between TEA an TDA
contribution limits: TEA better b/c tax adv on more savings (if cont limits are equal)
Adjusting for Unrealized Gain/ Loss
- asset sold today: +/- = MV - value of cg tax
- asset sold in future: +/- = MV - value of cg tax discounted by AT rasset
- asset sold in future: +/- = MV - value of cg tax discounted by AT rf
After Tax Risk and Return
σAT = σPT ( 1 - t )
rAT = rPT ( 1 - t )
corrAT = corrPT
Tax Alpha
value created by tax management
- TDA for heavily taxed items (bonds)
- TEA for lightly taxed items (equity)
GOALS: dec tax drag, dec TEA, trade less often, utilize TEA and TDA
Trading Behavior
- Trader: frequent trading, no deferred gains, low alpha
- Active Investor: less trading, some deferred gains
- Passive Investor: buy/hold, most gains deferred, high alpha
- Exempt Investor: no taxes
HIFO
highest in/ first out
designate highest tax lots to each sale
minimize gain, maximize loss
LIFO
lowest in/ first out
designate highest tax lots to each sale
when you expect higher taxes in future
Holding Period Management
usually tax advanatage to holding inv b/c tLT < tST
tLT = tST, still better to hold b/c pretax compounding return
year end: realize loss, defer gain = dec current taxes
Mean - Variance Optimization
- max after-tax return to after-tax risk
- optimize asset location
- structure allocations to pref tax locations
Probate
legal process, courts determine validity of will, inventories, and resolves disputes
AVOID WITH: joint ownership w/ survivorship, trust, retirement plans, life insurance
Wealth Transfer Taxes
- gift - gift tax
- bequest/ testamentary gratuitous transfers
- estate tax: paid by transferor
- inheritance tax: paid by recipient
Limitations on Distribution of Assest
- forced heirship: min share to children (+ others)
- community property rights: min share to surviving spouse
- separate property rights: spouse may own/ dispose of property indenpendently
- clawback provisions: force recipients to return gifts if they violate other rights
Estate Planning
objectives
- minimize taxes
- transfer assets to heirs and others
Individual’s Balance Sheet
- A: human capital, net employment capital > assets + PV future net income
- L: PV all current and future costs
- E: excess capital
Probability of Ruin
prob of portfolio = 0 based on different start dates and distribution percentages
RVtax free gift
RV > 1 = gift
RV < 1 = bequest after death
RVtaxable gift
(paid by receiver)
RV > 1 = gift
RV < 1 = bequest after death
RVtaxable gift
(paid by giver)
RV > 1 = gift
RV < 1 = bequest after death
RVtax exempt charity
RV > 1 = gift
RV < 1 = bequest after death
Tio = tax rate on ordinary income
Relief from Double Taxation
- exemption: income taxed by source not taxed by residence country
- credit: source tax provides credit against residence tax
- deduction: source country tax reduces taxible income in residence
Value of Generationg Skipping
skipping generations while passing down inheritences
value to 3rd gen increased by a factor of 1 / ( 1 - t )
(assuming r is same for all generations)
Valuation Discounts
reduce taxable value for difficult to value assets (takes liquidity and minority interest into consideration)
Value = MV*(1 - discountliquidity)*(1 - discountminority int)
Trusts
- revocable: settlor can rescind trust, settlor is owner
- irrevocable: settlor relinquishes ownership, trustee controls (tax benefits), protext assets from claims against settlor
- fixed: settlor determines how assets are distributed
- discretionary: trustee determines how assets are distributed
- spendthrift: trust b/c beneficiary is young or bad w/ money
Nominal Pre-Tax Return
*100% of nominal after-tax return is taxable
nominal pre-tax return = ( nominal after-tax return )/( 1 - t )
