Managing Individual Investor Portfolios

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					Chapter 2
   The Inger family resides in a politically stable country whose
    currency trades at a fixed exchange of 1:1 with the euro. Both
    real GDP growth an inflation average about 3% annually, resulting
    in nominal annual growth of about 6%. The country maintains a
    flat tax of 25% on all personal income and a net capital gains tax
    of 15%, with no distinction between ST and LT holding periods.
    The code also has a wealth transfer tax where any asset transfer
    between 2 parties is taxed at a flat rate of 50%.
   Their country maintains a national pension plan but there is
    uncertainty about its viability. Due to questions about the
    financial security of future retirees, the country has created self-
    contributory, tax-advantaged investment accounts for
    individuals. Taxpayers may contribute up to €5,000 of after-tax
    income to retirement savings accounts. The returns are exempt
    from taxes and participants can make tax-free withdrawals of
    any amount at age 62.
   The family has no IPS or stated guidelines. Peter and Hilda have
    been married for 37 years and have two children, Christa, aged
    25, and Hans, aged 30. Peter is 59 and a successful entrepreneur
    who founded a boat manufacturing business when he was 23. He
    built the company which now sells luxury boats worldwide but is
    considering a succession plan and retirement. Peter wants to
    monetize his equity stake and believes he can sell the company
    in the next 3 months. He is evaluating 3 bids that indicate
    probable proceeds, net of taxes on gains, of €55 million to the
    family in total. The 4 family members are the sole shareholders
    and money will accrue to them in proportion to their % ownership
   Hilda is 57 and comes from a wealthy family. She is the
    beneficiary of a trust established by her family. Throughout her
    lifetime her trust will distribute to her an inflation-indexed
    annual payment (currently €75,000) which is taxed as personal
    income. At her death, the payments will stop and the remaining
    money will go to a local charity.
   Hans and Christa are both unmarried. Hans is a senior VP at
    IngerMarine and specializes in boat design. Peter has tried to
    involve Christa but she has resisted and achieved moderate
    recognition and financial success as an artist. Christa has a 5
    year old son whom she is raising alone.
   Situational – characterize individual investors
    by stage of life or by economic circumstance

    ◦ source of wealth

    ◦ measure of wealth

    ◦ stage of life
   Foundation stage:
    ◦ Establishes base for wealth creation (skill, education, business
    ◦ Relatively young, long time horizon, increased ability to accept risk
    ◦ Need for liquidity may outweigh risk tolerance
   Accumulation stage
    ◦ Rising income and expenses (marriage, children, home)
    ◦ Later income still rises but expenses decline (children grow up, home
      paid off), increasing ability to save
    ◦ Increased wealth and still-long time horizon increase risk tolerance
   Maintenance stage (early retirement)
    ◦ Need to maintain lifestyle and financial security
    ◦ Shorter time horizon, less risk tolerance
    ◦ Some risky assets needed to preserve purchasing power
   Distribution stage
    ◦ Gifting to heirs or charities
    ◦ Tax constraints require early planning
   Life events can send an investor backward (new career or
    family) or forward (injury or illness) to a different stage
Net Worth                                         Figure 2.1

Accumulation        Consolidation Phase Spending Phase
Phase                                   Gifting Phase
Long-term:          Retirement          Long-term:
Retirement                                     Estate
      Children’s                        Planning
college             Vacations
Short-term:         Children’s College         Lifestyle
      House                             Needs Gifts

      25           35      45       55       65          75
   Personality plays an important role in
    establishing investor’s risk tolerance and
    return objectives
   Bridges the gap between traditional finance
    and behavioral finance
   Traditional finance measures objective
    circumstances, and assumes investors are risk
    averse, hold rational expectations and practice
    asset integration (portfolio context)
   Behavioral finance assumes investor
    psychology leads investors to be loss averse,
    hold biased expectations and practice asset
    segregation (each asset viewed independently)
   Investors are loss averse
    ◦ Do not view risk as uncertainty but rather as the potential for
      gain or loss
    ◦ More weight placed on losses than on gains
    ◦ Actually seek risk to avoid a certain loss even when resulting in
      lower expected value
   Investor expectations are biased
    ◦ Overconfident about future predictions
    ◦ Overestimate significance of rare events and the
      representativeness of one asset for another
   Investors segregate assets
    ◦ Do not consider interaction
    ◦ Segregate into mental accounts by purpose or preference
   To accommodate behavior, portfolios should be constructed
    to include subjective constraints and be layered to reflect
    asset segregation (with the layers forming an integrated
1. Policy statement - Focus: Investor’s short-term
  and long-term needs, familiarity with capital
  market history, and expectations
2. Examine current and project financial, economic,
  political, and social conditions - Focus: Short-term
  and intermediate-term expected conditions to use
  in constructing a specific portfolio
3. Implement the plan by constructing the portfolio -
  Focus: Meet the investor’s needs at the minimum
  risk levels
4. Feedback loop: Monitor and update investor
  needs, environmental conditions, portfolio
   The Smith Family Portfolio’s primary focus is the
    production of current income, with long-term capital
    appreciation a secondary consideration. The need
    for a dependable income stream precludes
    investment vehicles with even modest likelihood of
    losses. Liquidity needs reinforce the need to
    emphasize minimum-risk investments. Extensive
    use of short-term investment-grade investments is
    entirely justified by the expectation that a low-
    inflation environment will exist indefinitely into the
    future. For these reasons, investments will
    emphasize U.S. Treasury bills and notes,
    intermediate-term investment-grade corporate debt,
    and select “blue chip” stocks whose dividend
    distributions are assured and whose price
    fluctuations are minimal.
   For Clients:
    ◦ Educational process
    ◦ Reduces need to blindly trust adviser
    ◦ Portable document if change in advisers or second
      opinion is necessary
   For advisers:
    ◦ Protects adviser
    ◦ Can clarify motivation for decisions
    ◦ Can help identify questionable situations before
      they become serious
Inger Family Data

Income (annual)

Peter salarya                       € 500,000
Hans salary                           100,000

Hilda trust payment                    75,000    aPeter   expects to receive a fixed annual pmt of €100,000
Christa (art sales)                    50,000    taxable as income from the IM pension plan starting in 5 yrs.

Peter Personal Assets                            bIM   equity values are pretax market values; the equity has

Home (paid for and jointly held)   € 1,200,000   a zero cost basis for purposes of taxation on capital gains.

IngerMarine company     equityb    60,000,000    The company pays no dividend.
Diversified equity securities         750,000

Fixed income securities             1,000,000    cBeginning    at age 62, Peter plans to take a fixed annual
Cash (money market fund)            1,000,000    distribution of approximately €5,000 (tax exempt).
Gold bullion                          500,000

RSAc                                   50,000

Hilda Personal Assets

IngerMarine company equityb        € 1,200,000

Hans Personal Assets
Home (net of mortgage)              € 200,000

IngerMarine company     equittyb    2,400,000
Diversified equity securities         200,000
Cash (money market fund)              100,000

Christa Personal Assets

IngerMarine company equittyb       € 1,200,000
Balanced mutual funds                  75,000
Cash (money market fund)               25,000
   differentiate between return requirement and
    return desire
    ◦ for example, the Inger’s current needs are being met by
      Peter’s salary of €500,000
    ◦ if IngerMarine is sold, they may require a return that
      replaces Peter’s salary – critical objective
    ◦ they may desire a return that accommodates their major
      acquisitions and will leave the children financially secure
      - important but less critical objective
   investor who has retirement goals that are
    inconsistent with current assets and risk
    tolerance may need to:
    ◦ move back date of retirement
    ◦ accept reduced standard of living
    ◦ increase current savings
                                   Current      1              2          3            4            5
Salary (taxed as income)             500,000
Trust pmt (taxed as income)           75,000        77,250     79,568     81,955       84,413       86,946
Pension (taxed as income)                                                                          100,000
RSA (tax-free)                                                                5,000        5,000        5,000
Sale of firm (taxed as gain)                   61,200,000
Total Inflows                        575,000   61,277,250      79,568     86,955       89,413      191,946

Income tax (25%)                    -143,750        -19,313    -19,892    -20,489      -21,103      -46,737
Gains tax (15%)                                 -9,180,000
Second home                                     -7,000,000
Inv. in magazine                                -5,000,000
Support for Jurgen                                  -15,000    -15,450    -15,914      -16,391      -16,883
Transfer tax on support (50%)                        -7,500     -7,725     -7,957       -8,196       -8,442
Living and Misc. expenses           -500,000     -515,000     -530,450   -546,364     -562,754     -579,637
Total Expenses                      -643,750   -21,736,813    -573,517   -590,724     -608,444     -651,699
Net Additions/Withdrawals            -68,750   39,540,437     -493,949   -503,769     -519,031     -459,753

inflation assumed at 3% annually
Investable Assets, Net Worth, and Required Returns

Investable Assets                             Amount                  % of Net Worth

Year 1 CF                                              € 39,540,437             77%
Stock Holdings                                             750,000               1%
Fixed-income Holdings                                    1,000,000               2%
Cash Equivalents                                         1,000,000               2%
RSA Account                                                 50,000               0%
Total                                                  € 42,340,437             83%
Real Estate
First Home                                              € 1,200,000              2%
Second Home                                              7,000,000              14%
Total                                                   € 8,200,000             16%
Gold                                                     € 500,000               1%
Net Worth                                              € 51,040,437           100%

Required Return
Distributions in Year 2                                  € 493,949            1.17%
Divided by Investable Assets                           € 42,340,437
Plus Expected Inflation                                        3%             4.17%
   ways to determine risk objectives may differ
    but all must address these questions
    (quantitative measure is most appropriate)
    ◦ What are the investor’s financial needs and goals,
      both long term and short term?
    ◦ How important are these goals? How serious are the
      consequences if they are not met?
    ◦ How large an investment shortfall can the investor’s
      portfolio bear before jeopardizing its ability to meet
      major short- and long-term investment goals?
   income tax - % of total income
   capital gains tax – tax on price appreciation
    that comes when asset has been sold
   wealth transfer tax – tax due when assets
    have been transferred but not sold
    ◦ estate taxes
    ◦ gift taxes
   property tax – tax on real estate (sometimes
    on financial assets)
   Universal and complex
    ◦   Income tax
    ◦   Gains tax (profits on investments)
    ◦   Wealth transfer tax (gift or estate taxes)
    ◦   Property tax (real or financial property)
   Investment plans must be based on after-tax
   Tax deferral – more frequent periodic payments
    diminish wealth, so some plans try to defer tax
    payment as long as possible
   Tax avoidance – tax exempt investments typically
    come at expense of lower returns, liquidity or control
   Tax reduction – different rates for income or gains
   Wealth transfer – Early transfers (pre-death) may be
    desirable and also may result in longer tax deferral
                      Figure 2.5
         Investment                $10,063


Effect of Taxes on Portfolio Performance
Periodic 25% Tax
    Year             Beg. Value            Returns   (Tax 25%)   End Value           Cum. Gain
      1                     100,000        10,000     2,500                107,500             7,500
      2                     107,500        10,750     2,688                115,563            15,563
      3                     115,563        11,556     2,889                124,230            24,230
      4                     124,230        12,423     3,106                133,547            33,547
      5                     133,547        13,355     3,339                143,563            43,563

Cumulative 25% Tax
    Year             Beg. Value            Returns   (Tax 25%)   End Value           Cum. Gain
             1              100,000        10,000       n/a                110,000            10,000
             2              110,000        11,000       n/a                121,000            21,000
             3              121,000        12,100       n/a                133,100            33,100
             4              133,100        13,310       n/a                146,410            46,410
             5              146,410        14,641       n/a                161,051            61,051
                 Less 25% Tax                        15,263      145,788             45,788
   Regular IRA - tax deductible
    ◦ withdrawals taxable
   Roth IRA - not tax deductible
    ◦ tax-free withdrawals possible
   Annuities
   Employer’s 401(k) and 403(b) plans
   need to find asset class weights consistent
    with return objective, risk tolerance, and
   complete from a taxable perspective
    ◦ after-tax returns
    ◦ tax consequences of shift from current portfolio
    ◦ impact of future rebalancing
    ◦ asset “location”
      ie, nontaxable investments should not be “located” in
       tax-exempt accounts
    Selecting the most satisfactory asset
     allocation for an investor consists of
     four steps.
    1. Determine asset allocations that meet
       return requirement (total, after tax return)
    2. Eliminate allocations that fail to meet
       quantitative risk objectives or are
       inconsistent with investor risk tolerance
    3. Eliminate allocations that fail to satisfy
       other investor constraints
    4. Select from remaining allocations that which
       offers the best risk-adjusted performance
       and diversification
Exhibit 2-9 Proposed Asset Allocation Alternatives

        Asset Class            Projected   Expected                 Allocation
                              Total Return     σ       A      B         C         D      E
Cash Equivalents                 4.50%      2.50%     10%    20%       25%       5%     10%
Corporate Bonds                  6.00%      11.00%     0      25        0         0      0
Municipal Bonds                  7.20%      10.80%     40     0         30        0      30
Large-cap US Stocks             13.00%      17.00%     20     15        35       25      5
Small-cap US Stocks             15.00%      21.00%     10     10        0        15      5
International Stocks (EAFE)     15.00%      21.00%     10     10        0        15      10
REITs                           10.00%      15.00%     10     10        10       25      35
Venture Capital                 26.00%      64.00%     0      0         0        15      5

Total                                                 100%   100%       100%     100%   100%

Summary Data                   A        B          C          D      E

Expected Total Return         9.90%   11.00%     8.80%      14.40% 10.30%

Expected AT Total Return      7.40%   7.20%      6.50%      9.40%   7.50%

Expected Standard Deviation   9.40%   12.40%     8.50%      18.10% 10.10%

Sharpe Ratio                  0.574   0.524      0.506      0.547   0.574
Exhibit 2-10 Asset Allocation Alternatives: Nominal and Real Expected Returns


Return Measure                           A            B             C            D       E

Nominal Expected Return                    9.90%      11.00%      8.80%         14.40%   10.30%

Expected Real AT Return                    3.40%       3.20%      2.50%         5.40%    3.50%
1.       Return Requirement – 3% real after-tax
     ◦    allocations A, B, D, and E meet requirement
2.       Risk Tolerance – worst case nominal return
         of -10% in any 12 month period
     ◦    expected return less 2 times σ is good baseline –
          allocations A and E meet requirement
3.       Constraints – allocations A and E meet
         stated constraints
4.       Risk-Adjusted Performance and
         Diversification Evaluation
   Creates path-dependent scenarios based on
    probability distribution to predict end-stage results
   Superior to steady-state (deterministic) forecasting
    because incorporates variability across long-term
    assumptions and impact of resulting paths on
    ending wealth
   Generates probability distribution of ending wealth
    rather than a single point estimate
   Gives insight on trade-off between short-term risk
    and long-term failure to achieve objective
   Can capture volatility due to varying tax
   More closely approximates likely investment
   advantages to using as compared to a
    deterministic approach:
    1. more accurately portrays the risk-return tradeoff
    2. gives information on possible tradeoff between
       short-term risk and the risk of not meeting a
       long-term goal
    3. can capture the variety of portfolio changes that
       can potentially result from tax effects
    4. better able to model the stochastic process of
       calculating future returns and the alternative
       outcomes resulting from the process
   not all commercially available Monte Carlo
    products generate equally reliable results –
    things to be aware of:
    ◦ be wary of simulation tool that relies only on
      historical data
    ◦ choose a product that simulate the performance of
      specific investments, not just asset classes
    ◦ make sure it takes into account the tax
      consequences of investments