SS04 Flashcards
What are the 3 parts in the Situational Profiling?
Source of wealth, perceived wealth x needs, stage of life
Why do the Situational Profiling?
Can provide insights to risk tolerance and return objectives.
Two types of source of wealth
Created actively or passively
Examples of wealth created actively
Entrepreneurial activities
How do people who created wealth actively tolerate risk?
Have taken business risk before, they might take investment risk. Above-average willingness to tolerate risk.
How can willingness to take risk be measured?
Willingness can be indicated by both statements and actions.
Examples of wealth created passively
Inheritance, windfall, or through long, secure, employment and conservative investing
How do people who created wealth passively tolerate risk?
Below average willingness to take risk. Heirs have little faith of regaining the money should they experience significant losses. Employment and conservative investing means delayed consumption and low-risk investments.
How does the Measure of Wealth relates to risk?
Positive correlation between a clients perceived wealth and his willingness to take investment risk.
How can investors in the early stages of life manage market market downturns?
Investors in the early stages of life can add to their portfolio through employment-related income and therefore can manage short-term market downturns.
What are the Life Stages
Foundation, Accumulation, Maintenance, Distribution
Explain the Foundation Life Stage
Seeking to accumulate wealth, long time horizon. Little ability to take risk. Those who inherit have a long time horizon AND ability to take risk.
Explain the Accumulation Life Stage
Maximum savings and wealth accumulation, with a higher ability to take risk.
How is risk assessed at the Maintenance (Retirement) Life Stage
Ability to take risk will be declining but is probably not low (life expectancy is high!). Being too conservative can lead to a decline in standard of living.
Explain the Distribution Life Stage
assets exceed any level of need for the individual and a process of distributing assets to others can begin. For the wealthy, financial objectives can extend beyond their death, so that time horizon remains long and ability to take risk can remain high.
How does Tradicional Finance sees Risk Aversion?
Minimize risk for a given level of return, or maximize return for a given level of risk. Measure risk as volatility.
How does Tradicional Finance sees Rational expectations?
Investor’s forecasts are unbiased and accurately reflect all relevant information pertaining to asset valuation.
How does Tradicional Finance sees Asset Integration?
Investor’s consider the correlation of a potential investment with their existing portfolios.
What can be expected when constructing a portfolio, according to Asset Integration?
Asset prices will reflect economic factors, and portfolios can be constructed using weighted average returns, covariance and correlation.
How does Behavioral Finance sees Loss aversion?
Phrased as a gain, they take certainty, which is consistent with traditional finance. Phrased as a loss, they take uncertainty, hoping to avoid the loss.
Meaning of Biased Expectations, according to Behavioral Finance
Overconfidence in predicting the future.
What are the 3 types of Biased Expectations?
Assuming returns of the average manager will be those of a particular manager, excessively focusing on outlier events, mistakenly letting one asset represent another asset
How does Behavioral Finance sees Asset Segregation?
Do not consider the effect of correlation with other assets
How do investors tend to construct portfolios?
One asset at a time, instead of using asset integration.
How is Wealth creation determined?
Making investment decisions that relate to specific goals (e.g. pyramiding)
How can Personality Types be broadly assessed?
Questionnaires that focus on non-investment-related questions concerning personal attitudes and decision making.
What are the four Personality Types?
Cautious, Methodical, Individualistic, Spontaneous
Explain the Cautious Personality Type
Risk averse and base decisions on feelings, difficult to advise.
Explain the Methodical Personality Type
Risk averse and base decisions on thinking, constantly on the lookout for better information.
Explain the Individualistic Personality Type
Less risk averse and base decisions on thinking, very confident on their ability to make investment decisions.
Explain the Spontaneous Personality Type
Less risk averse and base decisions on feelings. Tend to doubt investment advice. High portfolio turnover, chase fads, continually want to do something.
For the client, the benefits of the IPS include
Identifies and documents investment objective and constraints
For the adviser, the benefits of the IPS include
Guidance for resolution of disputes (approving or dening client investment requests)
RRTTLLU
Return, Risk, Time Horizon, Taxes, Liquidity, Legal, Unique
Objectives and constraints of the IPS
Two objectives: return, then risk. Five constraints TTLLU
Where is ownership of a personal residence noted in the IPS
Usually under unique. It certainly not part of the investable assets.
Definition - Ability to take risk
How much volatility the portfolio can withstand and still meet the client’s required expenditures.
What affects ability to take risk
Significantly affected by the time horizon and size of the expenditures relative to the portfolio.
How to separate goals to assess ability to take risk
Separate goals under critical (providing for loved ones, future lifestyle) and secondary (lavish vacations).
How to assess willingness to take risk
Subjetive and determined through an analysis of the psychological profile. Look for statements of evidence in the client’s actions.
How should the risk objective be defined?
The risk objective should be as specific, relevant to the client, and measurable as possible. Past questions have often specified a maximum shortfall risk, usually defined as E(R) - 2 std deviations.
Where should the risk objectives be on the IPS?
It has been listed under both willingness and overall risk objectives, so both are acceptable.
What are the Individual Investor Constraints?
Five constraints - TTLLU - Time Horizon, Taxes, Liquidity, Legal, Unique
IPS constraints - Time Horizon
number of stages , main objective of each stage, and the number of years in each stage, if identifiable. Look for stages defined by people other than the client (inheritances)
Tax Strategies - Tax deferral - Definition
Minimize the potentially compounding effect of taxes by paying them at the end of the investment holding period.
Tax Strategies - Tax deferral - Applications
Strategies that fall under this category focus on long-term capital gains, low turnover, and loss harvesting
Tax Strategies - Tax avoidance - Definition
Invest in tax-free securities
Tax Strategies - Tax reduction - Definition
Invest in securities that require less direct tax payment
Tax Strategies - Tax reduction - Applications
Capital gains may be taxed at a lower rate than income, so securities that generate returns mainly as price appreciation offer the investor a lower effective tax rate
Tax Strategies - Wealth transfer taxes - Definition
Minimize transfer taxes by transfering wealth to others without utilizing a sale
IPS constraints - Liquidity
Liquidity can be important in affecting ability to bear risk and in details of the return calculation or SAA.
What limits liquidity in a portfolio?
The liquidity of assets and of a resulting portfolio is a function of the transaction costs to liquidate and price volatility of the assets.
How big should the liquidity be in a portfolio?
Holding three months to one year of the annual distribution in cash reserves could be reasonable if agreed in advance.
Definition - Personal Trust
Legal devices to transfer wealth to future generations
Definition - Revocable Trust
The grantor retains ownership and control over the trust assets and is responsible for taxes on any income or capital gains. The grantor often remains as trustee and either manages the trust assets or hires a manager.
Definition - Irrevocable Trust
The grantor confers ownership of the assets to the trust, which is managed by a professional trustee. The assets are considered immediately transferred to future generations and thus can be subject to wealth transfer taxes, such as gift taxes. The individual who originally funded the trust no longer has control of the assets and is not taxed on them.
Definition - Family Foundations
Similar to the irrevocable trust, used to transfer family assets to future generations. Family members remain as managers of the foundation’s assets.
