Private Wealth Mgt (1) Flashcards
Traditional Finance vs. Behavioral Finance
Risk aversion vs. Loss aversion
Rational beliefs vs. Biased expectations
Asset integration vs. Asset Segregation
Risk aversion vs. Loss aversion
Risk aversion = Prefer lower vol with same return
Loss aversion = Inv choices in terms of gains or losses (Prospect Theory - people are more distressed by prospect losses)
Rational beliefs vs. Biased expectations
Rational Beliefs = clear, coherent, and unbiased forecasters
Biased exp. = cogn. error resulting from overconfidence in predictive abilities
Asset integration vs. Asset Segregation
Asset integr. = Portfolio considers covariances between assets
Asset Segr. = Assets choices indiv., port. built as pyramids (“goal based”)
Ability & Willingness to take risk
Ability
Objective-quantitative
If inv. goals are modest relative to the size of the port., the investor has greater ability to take risk (can afford vol)
Longer inv horizon also contributes
Willingness
Subjective-qualitative
More subjective assessment
Professional and personal choices may give a hint (“…demonstrating tolerance for business risks that he may feel he controls…”, “…company debt decisions…”)
Return Methodologies
1. Spending Need Approach (for 1 year)
- Cash flow analysis (Inflows at the top, Outflows at the bottom)
- Return Objective = Net cash flow need in retirement (t+1) / Investible asset base (typically w/o personal residence)
- Nominal rate = real rate + inflation
2. IRR / Multi-Year Portfolio Approach (for n years)
Using calculator
(+) PV current investible assets
(-) FV terminal wealth at end of accum. phase spent in retirem.
(+ / -) PMT positive if cash flow into the port., negative if withdrawn from port
N number of years in the invest. horizon
IRR (pre or post tax, must be clear on the assumed base for each value)
5 Constrains (IPS)
- Liquidity (emergency cash + cash flow for expenses, consider transaction costs, illiquidity and price vol)
- Time Horizon (significant port rebalancing event, such as multi-stage, with pre and post-retirement)
- Tax concerns (max after-tax return, including tax avoidance)
- Legal & regulatory (Personal trusts, fiduciary capacity)
- Unique Circumstances (constrains port choice, such as concen. stock positions, BOD membership, etc.)
Irrevocable vs. Revocable Personal Trusts
Binary choice (control vs flexibility)
Irrevocable - Irrevocably, as the grantor, put the assets in a trust that I don’t control anymore (give power away). Grantor does not have any tax implications, nor have any control of the assets. The trust owns the assets, you have to appoint a trustee to make a decision wheater to distribute those assets to the inherited
Revocable - Totally flexible, grantor still have control over assets. Downside is that it is still taxable
Safety 1st rule
If E (r) - 2σ > client threshold return = accept portfolio
σ = std dev
Check the expected loss for 2 std dev to check if it is acceptable for the client’s port
Deterministic Model of Asset Allocation vs Monte Carlo (Probabilistic Analysis)
Deterministic = Mean-variance allocation, based on historical returns (giving the behavior the assets together, this is the portfolio with the highest return - 1 year). People get that x% of return and compound it for y years, w/o taking into account what may happen during this time
Monte Carlo = Probability Allocation model, path dependent. Multifactor model that includes tax, savings, mkt conditions, and others. It is a simulation tool that is still based on historical values (potential weakness). Analysis should go to the specific investment, not only asset classes
Sources of Taxes (after tax calculations)
1. Annual accrual taxes (periodic tax on return, interest)
FVi = $ [1 + r (1 - ti)] n
Annual tax has a greater impact due to compounding in higher returns and time horizons (tax drag)
Effective tax = [FV w/o taxes - FV w/ taxes] / [gain w/o taxes]
2. Deferred capital gains (tax once the asset is sold)
FVcg = $ [(1 + r) n * (1 - tcg) + tcgB]
B = Cost basis / Current mkt value
(ie. você volta com a base do tcg por que o imposto é apenas nos ganhos)
3. Wealth-based tax (periodic tax on the entire port value - ie. real estate)
FVw = $ [(1 + r) * (1 - tw)] n
Applies to the entire capital base (ie. principal and return), so it consumes a greater proportion when inv return are low
Effective capital gains tax rate (T*) and FVtaxable
T* = CG tax rate * (Proportion of gains not yet taxed) / (Proportion of account after-tax and deferred)
or
T* = tcg * (1 - pi - pd - pcg) / (1 - piti - pdtd - pcgtcg)
FVtaxable = (1 + r*) n (1 - T*) + T* - (1 - B) tcg
Types of Investment Accounts and main differences
- Taxable - regular
- Tax-Deferred (TDA) - tax-deferred until funds are withdrawn, at which time they are fully taxed at ordinary rates (have a built-in tax liability)
- Tax-Exempt (TE) - no future tax (tax-free even at withdrawn), but current contributions are taxed
TDA vs TE
TDA is taxed in the future, contribution on a pre-tax basis.
TE is taxed now (contribution on an after-tax basis)!
The only difference is the tax rate that will be ap plied. If T0 = Tn, then it will result in the same amount
Asset Location
- Place heavily taxed assets (bonds) in TDA or tax-exempts accounts. Place lightly taxed assets (equities) in taxable accounts. Also, it is best to invest riskier assets in taxed accounts.*
- [Bonds have more tax due to interest! E.g. short bond in TDA and buy equity in TEA]*
Methods to Capture Tax Alpha
- Tax Loss Harvesting (recognizing a realized tax loss that offsets a realized taxable gain - defer tax to another period ***lembra que você seguiria o mesmo investimento, ou seja, se vender agora, vai recomprar outra ação com o mesmo retorno. Assim, não muda o total do benefício, só o tempo que leva até você usá-lo. Só muda se você usar os savings para aumentar o seu principal.***)
- Holding Period Management (Diff in short term vs long term taxes)
Estate Planning Definitions
Estate
Will
Testator
Probate
Intestate
Inter vivos
Bequest
Sole ownership
Joint ownership
Total Estate
Community property
Separate property
Forced heirship rules
“Clawback” provision
Estate = all property a person owns (financial + tangible + immovable & IP) - exclude inter vivos
Will = outlines rights others have after one’s death
Testator = author of the will
Probate = legal process will’s validation
Intestate = die without a will (court will transfer assets)
Gifts or Inter vivos transfers = lifetime gratuitous transfer of asset
Bequest = transfer of asset after death
Forced heirship rules = children have a fixed share of total estate
“Claw-back” provision = bring back lifetime gifts into estate to calculate children’s share (in case of Forced heirship)
Community property = Each spouse is entitled to one-half of the estate
Separate property = Each spouse controls their own property
Core Capital - individual’s balance sheet
- Assets = Assets + financial assets + PV net employment income (i.e. Human capitalornet employment capital)
- Liabilities (core capital) = PV of all current and future costs necessary to sustain a given lifestyle (include mortgage or other loan payments, and expenses)
- Equity (excess, may be used for any purpose) = Assets - Liabilities.
Methodology of Calculating Core Capital
Methodology of Calculating Core Capital
- Core Capital with Mortality Tables
- Prob. (joint survival) = p(Husband survives) + p(Wife survives) - [p(Husband survives) * p(Wife survives)]
- Core Capitaln years = ∑ P (survt)(spendingt) / (1+rf)t
- May be adjusted for safety reserve
-
Core Capital with Monte Carlo Analysis
* Captures mkt volatility; path dependent; can incorporate smaller safety reserve
RV TaxFreeGift
RV TaxableGift (recipient pays)
RV TaxableGift (donor pays)
RV CharitableGift
