Reading 8 Managing Individual Investor Portfolios

Question 1

Situational profiling

Answer 1

Situational profiling seeks to anticipate individual investors’ concerns and risk tolerance by specifying the investor’s source of wealth, measure or adequacy of wealth in relationship to needs (economic circumstances), and stage of life.

Situational profiling should be considered only as a first step in understanding an individual`s preferences, economic situation, goals and desires.

Question 2

Source of Wealth

Answer 2

Some classification schemes presume that the manner in which an individual investor has acquired wealth offers insight into that investor’s probable attitude toward risk.

“Self-made” investors may have greater familiarity with risk-taking and a higher degree of confidence in their ability to recover from setbacks.

More-passive recipients of wealth may be associated with reduced willingness to assume risk.

Question 3

Measure of Wealth

Answer 3

1. It is difficult to categorize investors based on portfolio size (net worth).
2. It is not unreasonable to consider that investors who perceive their holdings as small may demonstrate lower tolerance for portfolio volatility than investors who perceive their holdings as large. A portfolio whose returns do not easily support the investor’s lifestyle might be considered small.
3. If the investor’s ongoing needs are so well covered that succession and estate planning issues have become important, the portfolio might be considered large.

Question 4

Stage of Life

Answer 4

individual’s investment policy can be viewed as passing through four general phases: foundation, accumulation, maintenance, and distribution.

• During the foundation phase of life, the individual is establishing the base from which wealth will be created.
• In the accumulation phase, earnings accelerate as returns accrue from the marketable skills and abilities acquired during the foundation period and gradually reach their peak.
• During the maintenance phase, the individual has moved into the later years of life and usually has retired from daily employment or the pressures of owning a business.
• In the distribution phase, accumulated wealth is transferred to other persons or entities.

Question 5

Psychological profiling

Answer 5

Psychological profiling addresses human behavioral patterns and personality characteristics and their effect on investment choices. It is particularly important in assessing risk tolerance.

Psychological profiling assumes investors exhibit phychological characteristics such as loss aversion, biased expectations and asset segregation.

Question 6

Traditional finance assumes all investors exhibit three major characteristics

Answer 6

In models of traditional, or standard, investment decision making, investors are assumed to:

• exhibit risk aversion;
• hold rational expectations;
• practice asset integration.

Rational expectations. Investor`s forecasts properly reflect all relevant information pertaining to security valuation.

Asset integration. Investors focus not only on an individual asset`s risk/return characteristics but also the correlation of the asset with the assets in the portfolio.

Question 7

Traditional models of the portfolio building process have historically relied on the following tenets

Answer 7

Traditional models of the portfolio building process have historically relied on the following tenets:

1. Asset pricing is driven by economic considerations such as production costs and prices of substitutes.
2. Portfolios are constructed holistically, reflecting covariances between assets and overall objectives and constraints.

Question 8

Behavioral finance assumes investors exhibit three phychological characteristics

Answer 8

Behavioral finance assumes investors exhibit three phychological characteristics:

• Loss aversion
• Biased expectations. This means investors have too much confidence in thier ability to forecast the future.
• Asset segregation. Instead of evaluation an investment`s impact on the overall portfolio position, investros focus on individual assets.

Question 9

Behavioral models of the portfolio building process relied on the following tenets

Answer 9

According to behavioral models of individual decision making, portfolio construction takes place under a more complex set of assumptions than those given previously:

1. Asset pricing reflects both economic considerations, such as production costs and prices of substitutes, and subjective individual considerations, such as tastes and fears.
2. Portfolios are constructed as “pyramids” of assets, layer by layer, in which each layer reflects certain goals and constraints.

Question 10

Personality typing approach

Answer 10

The primary value of any personality typing approach is to provide both the investor and the manager with a framework for thinking about the influence of personality on investment decision-making, not to neatly categorize investors into arbitrarily defined personality types.

A personality typing questionaire provides the investment manager and the client with some general classifications for the client`s prepensity to take risk. One such questionaire may ask the client to respond to non-investment-related questions and attempt to assign the client along two dimensions: (1) risk attitudes and (2) decision-making style

Question 11

4 types of investors due to the personality typing approach

Answer 11

1. Cautious investors focus on minimizing risk. They have difficulty making investment decisions and exhibit low portolio turnover.
2. Methodical investors have a conservative nature combined with a focus on gathering as musch data as possible. They are constantly on the lookout for new and better information.
3. Individualistic investors have a confidence in their investment decision making and are willing to do investment research. They are self-assured investors.
4. Spontaneous investors exhibit high portfolio turnover with associated high trading costs. They fear not reacting to changing market conditions, including the latest investment fads.

Question 12

Benefits of IPS to the Client

Answer 12

Benefits to the Client:

1. Objectives and constraits are condsidered in formulating investment decisions that benefit the client
2. The process is dynamic and allow changes in circumstances to be incorporated.
3. A well-written IPS represents the long-term objectives of the investor
4. Subsequent managers should be able to implement decisions congruent with the individual`s goals

Question 13

Benefits of IPS to the Adviser

Answer 13

Benefits to the Adviser:

1. The IPS can be consulted for clarification as the approprieteness of specfic investment decisions
2. Most IPSs contain a stated review process, indicate dispute resolutions, and identify potential problems

Question 14

Explain the process involved in creating an IPS

Answer 14

1. Determine and evaluate the investor`s risk and return objectives. Planning return expextations should take place concurrently with risk tolerance descussions.
2. Determine portfolio constraints.
3. Define the appropriate investment strategy based upon an analysis of objectives, constraints, and market expectations.
4. Determine the proper asset allocation to meet the investor`s objectives and constraints, An SAA (strategic asset allocation) is sometimes included

Question 15

Distinguish between required return and desired return and explain how these affect the individual investor`s IPS

Answer 15

• Required expenditures are mandatory objectives and, along with the value of the investable portolio, are used to calculate the client`s required return
• Desired expenditures are non-primary goals, such as buying a vacation home, taking lavish vacations, and the like, that are not considered when calculating the total investable portolio or required return

Question 16

Explain how to set risk and return objectives for individual investor portfolios and discuss the impact that ability and willingness to take risk have on risk tolerance

Answer 16

Ultimately, the return and risk objectives have to be consistent with reasonable capital market expectations as well as the client constraints. If there are inconsistencies, they must be resolved working with the client.

• All else equal, portfolio size versus needs, time horizon, and ability to take risk are positively related.
• Goal importance, level of spending needs, and ability to take risk are negatevily related.
• Flexibility can increase the ability to take risk.
• Willingness to take risk is subjective.
• Explicit statements, client actions, and situational profiling are used to indicate the client`s willingness to take risk.

Question 17

Discuss the major constraint categories included in an individual investor’s investment policy statement

Answer 17

Portfolio constraints generally fall into one of five categories:

• liquidity;
• time horizon;
• taxes;
• legal and regulatory environment;
• unique circumstances.

Question 18

Time horizon constraint

Answer 18

1. Time horizon. The total time period over which the portfolio will be managed to meet the investor`s objectives and constraints.
2. A stage in the time horizon is indicated any time the individual experiences or expects to experience a change in circumstances significant enough to require evaluation the IPS and relocating the portfolio. This can include retirement and major expenses such as college costs, expected inheritance, et cetera. The most common time horizon is with two stages: “x years to retirement and retirement of 20-25 years.”
3. In many planning contexts, time horizons greater than 15 to 20 years can be viewed as relatively long term, and horizons of less than 3 years as relatively short term.

Question 19

Tax considerations constraint

Answer 19

1. General classificaions of taxes include income tax, capital gain tax, transfer tax, and wealth or personal property tax. Strategies used to reduce the adverse impact of taxes include tax deferral, tax avoidance, and transferring wealth to others without unilizing a sale.
2. The issue of taxes is perhaps the most universal and complex investment constraint to be found in private portfolio management.
3. Tax Deferral: for the long-term investor, periodic tax payments severely diminish the benefit of compounding portfolio returns. Many tax strategies, therefore, seek to defer taxes and maximize the time during which investment returns can be reinvested
4. Tax avoidance: Tax-advantaged investment alternatives typically come at a price, however, paid in some combination of lower returns, reduced liquidity, and diminished control.
5. Early transfers: the benefit of early wealth transfers is largely determined by tax codes and life expectancies. Additional issues to consider before making a permanent transfer include 1) the amount of retained wealth needed to ensure the financial security of the primary investor; 2) possible unintended consequences of transferring large amounts of wealth to younger, potentially less mature beneficiaries; and 3) the probable stability or volatility of the tax code

Question 20

Liquidity constraints

Answer 20

Liquidity refers generally to the investment portfolio’s ability to efficiently meet an investor’s anticipated and unanticipated demands for cash distributions. Two trading characteristics of its holdings determine a portfolio’s liquidity:

• Transaction Costs
• Price Volatility

Liquidity requirements can arise for any number of reasons but generally fall into one of the following categories:

• Ongoing Expenses
• Emergency Reserves
• Negative Liquidity Events

Question 21

Legal and regulatory factors constraints

Answer 21

Typically relate to tax relief and wealth transfer. The specific constraints vary greatly across jurisdictions and usually call for legal advise.

Question 22

The Personal Trust

Answer 22

1. Trust is a legal entity established to hold and manage assets in accordance with specific instructions.
2. The term “personal trust” refers to trusts established by an individual, who is called the “grantor.” The trust is a recognized owner of assets and can be subject to taxation in much the same manner that individuals are taxed. To form a trust, the creator (grantor) drafts a trust document defining the trust’s purpose and naming a trustee who will be responsible for oversight and administration of the trust’s assets. The trustee may or may not be the same person as the grantor.
3. The two basic types of personal trusts, revocable and irrevocable, differ largely with respect to the issue of control.
4. In a revocable trust, any term of the trust can be revoked or amended by the grantor at any time.
5. In an irrevocable trust, the terms of management during the grantor’s life and the disposition of assets upon the grantor’s death are fixed and cannot be revoked or amended. The creation of an irrevocable trust is generally considered to be an immediate and irreversible transfer of property ownership, and a wealth transfer tax, sometimes called a gift tax, may have to be paid when the trust is funded.

Question 23

Family Foundation

Answer 23

Similar to an irrevocable trust, the foundation is an independent entity, often governed by family members. Such foundations can be part of a multigeneration estate plan and often serve as a vehicle for introducing younger family members to the process of managing family assets.

Question 24

Unique circumstances constraints

Answer 24

Special investment concerns; special instructions; restrictions and the sale of assets; asset classes the client specifically forbids or limits based on past experience; and outside the investable porfolio, such as a primary or secondary residence, bequests, and desired objectives not attainable due to time horizon or current wealth.

Question 25

Prepare and justify an investment policy statement for an individual investor;

Answer 25

The IPS is a document that is developed as the result of a client interview to determine their risk (ability and willingness) and return objectives and the five constraints, which consist of the time horizon, unique circumstances, taxes, legal and regulatory, and liquidity constraints. An *asset* *allocation* for the client`s portfolio is then determined and implemented, monitored, and subsequently revised as need depending on changes in the client`s circumstances as reflected in a periodic review of client`s IPS.

Question 26

reasonable baseline measure of shortfall risk?

Answer 26

The expected return less two times the portfolio risk (expected standard deviation) is a reasonable baseline *measure of shortfall risk*

Question 27

_determine_ the strategic asset allocation that is most appropriate for an individual investor’s specific investment objectives and constraints

Answer 27

1. The key is selecting the allocation that best matches the objectives and constraints of the invesrot, but that`s easier said than done. A *process of elimination* can help by removing allocations that have a slim chance of satisfying all the objectives and constraints. 2. **The process of elimination** begins by selecting thosse allocations generating returns that meet the *return objective* of the investror. Next, the manager should choose allocations that do not violate statements relating to risk or safety-first rules (worst case returns). This second step may require calculations (substracting two standard deviations from the expected return).

Question 28

_compare_ Monte Carlo and traditional deterministic approaches to retirement planning and _explain_ the advantages of a Monte Carlo approach

Answer 28

Deterministic planning techniques use *single values* for economic and financial variables. For instance, expected rates of returnes, inflation, and interest rates are assigned single point estimates and then used in a modelling framework to estimate investment outcome at the retirement stage of life, the deterministic estimation process generates *only a single number*. Investors do not have the capability of evaluating probabilities of that expected value occuring. **Motte Carlo techniques** take into account distributions and associated probabilities for input variables and generate a probabilistic forecast of retirement period values. Instead of seeing one single outcome, the investor can see a range of possibilities for the future. Advantages of a Monte Carlo approach: * probabilistic forecasts give both the client and the manager a *better indication of the risk/return tradefoff* in investment decision. * Monte Carlo simulations explicitly *show tradeoffs* of short-term risks and the risks of not meeting goals. * Monte Carlo is better able to *incorporate tax nuances*. * Monte Carlo can better *model the complications* associated with future returns by more efficiently incorporating coumpounding effect of reinvestment.

Question 29

on what basis are made investment decisions for individual investors?

Answer 29

For individual investors, investment decisions, including asset allocation, are made on an after-tax basis. This is a key distinction in contrast to tax-exempt institutions.

Question 30

division of return requirements between “income” and “growth” objectives - shortcomes?

Answer 30

The traditional division of return requirements between “income” and “growth” objectives may seem intuitive, but these terms blur the distinction between return goals and risk tolerance. The “total return” approach seeks to identify a portfolio return that will meet the investor’s objectives without exceeding the portfolio’s risk tolerance or violating its investment constraints.

Question 31

How to derive risk pbjectives based of on the client`s willingness and ability to take risk?

Answer 31

Your concluaion should generally go with the more conservative of the two. If there is a conflict between the two, it should definately be pointed out. It can be the average of the two if there is no seious conflict between them.

Question 32

Return before tax and Return after tax

Answer 32

Return before tax = (Return after tax + inflation)/(1-tax)

Question 33

Compare Buy and Hold, CPPI (constant proportion potrfolio insurance strategy) and Constant Mix rebalancing strategies in terms of performance in trending and flat but oscillating markets

Answer 33

* The *Buy and Hold strategy* outperforms a Constant Mix strategy in a trending market and outperforms the CPPI strategy in a flat buy oscillating market. * The *Constant Mix strategy* outperforms a comparable Buy and Hold strategy, which, in turn, outperforms a CPPI strategy in a flat but oscillating market. * The *CPPI strategy* outperforms a comparable Buy and Hold strategy, which, in turn, outperforms a Constant Mix strategy in trending markets.

Question 34

Constant-Mix Investing

Answer 34

This is a dynamic asset allocation strategy. The objective of constant-mix is to maintain a ratio of, for example, 60% stocks and 40% bonds, within a specified range by rebalancing. You are forced to buy securities when their prices are falling and sell securities when they are rising relative to each other. Constant-mix strategy takes a contrarian view to maintaining a desired mix of assets, regardless of the amount of wealth you have. You essentially are buying low and selling high as you sell the best performers to buy the worst performers. Constant-mix becomes more aggressive as stocks fall and more defensive as stocks rise.

Question 35

Which step is often considered the first hurdle in the elimination process?

Answer 35

The first step in the elimination process is to select those allocations that at least meet the real after-tax total *return objective* of the investor.