CFA 2018 level 3 schweser practice exam CFA 2018 level 3 question bank CFA 2018 CFA 2018 r08 managing individual investor portfolios IFT notes

Managing Individual Investor Portfolios IFT Notes Managing Individual Investor Portfolios Introduction Case Study Investor Characteristics 3.1 Situational Profiling 3.2 Psychological Profiling Investment Policy Statement 4.1 Setting Return and Risk Objectives 4.2 Constraints An Introduction to Asset Allocation 10 5.1 Asset Allocation Concepts 10 5.2 Monte Carlo Simulation in Personal Retirement Planning 12 Appendix A – The Inger Family Case Study 14 Summary 18 This document should be read in conjunction with the corresponding reading in the 2018 Level III CFA® Program curriculum Some of the graphs, charts, tables, examples, and figures are copyright 2017, CFA Institute Reproduced and republished with permission from CFA Institute All rights reserved Required disclaimer: CFA Institute does not endorse, promote, or warrant the accuracy or quality of the products or services offered by IFT CFA Institute, CFA®, and Chartered Financial Analyst® are trademarks owned by CFA Institute IFT Notes for the Level III Exam www.ift.world Page Managing Individual Investor Portfolios IFT Notes Introduction This may be the most important reading of the Level III curriculum It demonstrates how to create an investment policy statement (IPS) for individual investors Throughout this reading, and for the IPS questions on the exam, put yourself in the position of an advisor working with clients Case Study The Inger family case is used to illustrate lessons throughout this reading The income and asset data listed in Table is essential for calculating return objectives In addition to this financial data, Victoria Jourdan’s (the financial advisor) observations in Box include notes on the personalities and goals of the members of the Inger family This is consistent with incorporating a behavioral finance perspective into the process of developing a client’s IPS The case study is presented in Appendix A Investor Characteristics Individuals not always act like Rational Economic Men Behavioral bias, both cognitive and emotional, can cause investors to deviate from the mean-variance optimal portfolio that matches their risk tolerance and return objectives As was discussed in section 2.1 of Behavioral Finance and Investment Processes, advisors are limited in what they can learn about their client based solely on demographic details (situational profiling) It is possible to develop a deeper understanding of investors by identifying their behavioral biases (psychological profiling) 3.1 Situational Profiling Situational profiling is the process of discovering an investor’s basic financial and demographic information, which is then used to assist the advisor in recommending an appropriate asset allocation In the example used in this reading, Victoria Jourdan, the investment advisor, begins her relationship with the Ingers by meeting with Peter and Hilda and recording their financial situation, which is summarized in Table She also learns of their timeframe for selling IngerMarine (their family business) and their plans to build a second home and to purchase a minority position in a photography magazine This is situational profiling, and while this is by no means the only information that Jourdan will need, it is a “useful first step” on the way to achieving her objective of recommending an asset allocation and investment plan The factors discussed in sections 3.1.1 to 3.1.3 are components of an investor’s situational profile and are helpful in assessing risk tolerance These sections cover: LO.a: Discuss how source of wealth, measure of wealth, and stage of life affect an individual investors’ risk tolerance 3.1.1 Source of Wealth Recall the distinction between active and passive investors described in the Barnewall Two-Way Model, which was presented in section 2.1.1 of Behavioral Finance and Investment Processes Active investors have generated wealth by risking their own capital (for example, entrepreneurs) and they are assumed IFT Notes for the Level III Exam www.ift.world Page Managing Individual Investor Portfolios IFT Notes to have a higher risk tolerance than passive investors, who have accumulated wealth by earning a salary (or perhaps from inheritance) As a general rule, investors with greater risk tolerance will allocate a higher share of their portfolio to equities and a lower share to fixed income securities and cash In the example from this reading, Peter Inger is a successful entrepreneur who has acquired his wealth by actively risking his own capital, which is an indication of a higher willingness to hold a portfolio with a higher proportion of riskier assets This is one factor to consider when determining an investor’s overall risk tolerance, which is covered in section 4.1.2 3.1.2 Measure of Wealth An investor can be considered wealthy if portfolio returns substantially exceed spending needs Wealthy investors are likely to have high risk tolerance On the other hand, if portfolio returns not easily support an investor’s lifestyle, risk tolerance is likely to be low In the case of Peter and Hilda Inger, their annual living expenses are currently €500,000 and their investable asset base (net of taxes) after selling IngerMarine will be more than €42,000,000 (see Exhibit 5) By any standard, this couple can be referred to as having a high level of wealth, which indicates high ability to take investment risk 3.1.3 Stage of Life An individual’s investment policy passes through four general phases: foundation, accumulation, maintenance, and distribution Foundation During this phase the individual is establishing the base from which wealth will be generated Typically the investment horizon is long and the risk tolerance is moderately high in the foundation phase Accumulation During this phase earnings increase as a result of the skills developed in the foundation phase Increased wealth coupled with an investment horizon which is still long results in higher risk tolerance for most investors Maintenance During this phase individuals retire and preserving wealth and living off the portfolio return becomes important The risk tolerance is usually low in this phase Distribution During this phase, accumulated wealth is transferred to other persons or entities Dealing with tax constraints is important in this phase The key takeaway from this section is that, as a general rule, investors who are closer to retirement have less ability to take investment risk than those who have a longer time horizon and can recover from periods of low (or even negative) returns The idea of holding a smaller proportion of riskier assets as one approaches retirement has been formalized in the “glide path” portfolio, which was discussed in section 4.1 of Behavioral Finance and Investment Processes (see Example 1) It is important to note that the path through these life stages is not necessarily linear For example, an investment fund manager who makes a mid-career decision to become a chef will go from the accumulation stage “back” to the foundation stage Another important caveat to the general rule mentioned above is that an investor who plans to pass wealth on to her heirs will have a time horizon that extends beyond her life expectancy However, all else equal, a 35 year-old investor who is 30 years IFT Notes for the Level III Exam www.ift.world Page Managing Individual Investor Portfolios IFT Notes from retirement will have a greater ability to take investment risk than a 60 year-old investor who is years from retirement This concept is discussed further in the context of an investor’s risk tolerance (see section 4.1.2) 3.2 Psychological Profiling As noted in section 3.1, situational profiling is a “useful first step” for an advisor seeking to understand his clients’ economic circumstances and, in particular, their ability to take risk Similarly, psychological profiling can help an advisor develop a better understanding of his clients’ motivations and, in particular, their willingness to take risk Personality typing schemes are a tool to assist with the psychological profiling process The personality typing scheme discussed in this section uses responses to questions such as those listed in Exhibit to plot investors along two dimensions; risk tolerance and decision-making style Investors are then assigned one of four personality types, which are summarized in the table below: Investor type Risk tolerance Decision-making style Spontaneous Less risk averse Based primarily on feeling Cautious More risk averse Based primarily on feeling Individualist Less risk averse Based primarily on thinking Methodical More risk averse Based primarily on thinking Based on their responses, Jourdan classifies the Inger family members as shown in Exhibit The distinction between ability and willingness to take risk is important and will be discussed further in section 4.1.2 For the moment, it is sufficient to note that situational profiling relates to ability to take risk and psychological profiling provides insights into willingness to take risk This is the essence of LO.b: LO.b: Explain the role of situational and psychological profiling in understanding an individual investor’s attitude toward risk IFT Notes for the Level III Exam www.ift.world Page Managing Individual Investor Portfolios IFT Notes LO.c refers to how behavioral biases cause individuals to act irrationally LO.c: Explain the influence of investor psychology on risk tolerance and investment choices If individuals always acted like the Rational Economic Men that they are assumed to be according to the traditional finance perspective, there would be no insight to be gained from psychological profiling or classifying investors according to their personality type However, as has been covered extensively in The Behavioral Finance Perspective, The Behavioral Biases of Individuals and Behavioral Finance and Investment Processes, behavioral finance researchers have documented that individuals not always make perfectly rational economic decisions The table below summarizes the differences between how investors and markets are assumed to behave according to traditional finance and how they actually behave according to behavioral finance Investor risk tolerance Traditional Finance Perspective Behavioral Finance Perspective Investor are risk averse and will make choices that yield the greatest expected value Investors are loss averse and will take risky bets with lower expected values in order to avoid choosing a certain loss Market expectations Investors have rational expectations because they are perfectly rational, perfectly self-interested and have access to perfect information Investors have biased expectations for asset performance because behavioral biases prevent them from being perfectly rational Asset allocation Investors think about their money holistically and integrate assets that work within the context of their existing portfolio Investors evaluate each investment decision separately and fail to consider how their assets fit within the context of their overall portfolio Market behavior Markets are perfectly efficient and asset prices reflect all relevant information Asset prices deviate from their intrinsic value when investors act irrationally due to the influence of behavioral biases Portfolio construction Investors consider correlations between different assets and hold the mean-variance optimal portfolio that meets their return objectives and fits within their risk tolerance Investors build portfolios in layers, each of which has an asset allocation that reflects the importance of its associated goal Investment Policy Statement The material in this section addresses LO.d: LO.d: Explain potential benefits, for both clients and investment advisors, of having a formal investment policy statement Investors (or clients) trust advisors with their life savings, so it is essential to establish a formal IFT Notes for the Level III Exam www.ift.world Page Managing Individual Investor Portfolios IFT Notes agreement that defines the terms of this relationship This agreement is known as an investment policy statement (IPS) and it should be thought of as a contract that dictates what an advisor may (and may not) while entrusted to manage a client’s money From the client’s perspective, the benefits of an IPS include:  A better understanding of their financial situation  Increased knowledge of investment strategies and the advisor’s recommendations  The ability to take an IPS to another advisor for a second opinion or to establish a new advisory relationship From the advisor’s perspective, the benefits of an IPS include:  Creating an IPS results in a deep understanding of the client’s motivations and goals  Provides guidance for investment decision making  Most importantly, an advisor can refer to the guidelines set out in the IPS if asked to explain her decisions Adhering to the terms of an IPS is a solid defense against allegations of breaching one’s fiduciary duty LO.e is not specific to any section of this reading: LO.e: Explain the process involved in creating an investment policy statement For exam purposes, you should have a thorough understanding of the key components of an IPS, which are the objectives (return and risk tolerance) and constraints (liquidity, time horizon, taxes, legal and regulatory environment, and unique circumstances Each of these items is addressed in this section A proper IPS will also include guidelines on asset allocation (see section 5) and performance monitoring, which is covered extensively in Monitoring and Rebalancing 4.1 Setting Return and Risk Objectives 4.1.1 Return Objective This first part of this section addresses LO.f: LO.f: Distinguish between the required return and desired return and explain how these affect the individual investor’s investment policy A required return is the rate of return that must be achieved in order to fund a client’s primary or critical long-term objectives For example, at a minimum, clients will want to maintain their current standard of living Other primary objectives might include paying for a child’s education A desired return is the rate of return that is necessary to fund a client’s secondary goals For example, purchasing a second home or making a large charitable donation Historically, return requirements were usually classified as income and growth But the curriculum suggests that it is better to use the total returns approach IFT Notes for the Level III Exam www.ift.world Page Managing Individual Investor Portfolios IFT Notes The return objective will also specify whether the return is nominal (including inflation) or real and pretax or after-tax Ultimately, a targeted rate of return must be achievable within the context of an investor’s risk tolerance In the event that an investor’s desired (or even required) return is unrealistic, he will need to consider one or more of the following measures:  Modifying short-term goals (for example, delaying plans for a home renovation)  Modifying risk tolerance by increasing his portfolio’s allocation to riskier assets  Deferring retirement  Accepting a lower standard of living in retirement  Increase savings by accepting a lower current standard of living  Increase savings by earning additional income The remainder of this section addresses the return objective component of LO.g: LO.g: Explain how to set risk and return objectives for individual investor portfolios Calculating an investor’s return objective In the context of the exam, return rates are typically calculated by dividing the cash flows that an investor requires from his portfolio by his investible asset base For example, in Exhibits and 5, Victoria Jourdan estimates that the Ingers will need to withdraw €493,949 from their portfolio in Year 2, which will come from an investable asset base that is projected to be worth €42,340,437 at the end of Year Having determined these numbers, it is a simple matter to calculate a required real return rate of 1.17% Alternatively, you may be provided with the current value of the investor’s portfolio (PV), the number of years until planned retirement (N), the annual contributions to or withdrawals from the portfolio (PMT), and the portfolio value required to meet the investor’s needs during retirement (FV), which allows you to solve for I/Y Whichever method is used, there some important issues to consider when determining a return objective Nominal vs Real Return Be sure to note whether you have been asked to calculate a real or nominal rate of return As mentioned, Jourdan calculates the real required return of 1.17% and then adds 3% expected inflation to produce a nominal expected return of 4.17% Pre-tax vs After-tax return (See Asset Allocation, Section 3.2) Maintain a consistent approach with respect to pre-tax and after-tax returns For example, if an investor requires after tax income of $75,000 from his investments and the applicable tax rate is 25%, he will need to withdraw $100,000 from his portfolio Similarly, if an asset allocation offers a pre-tax return of IFT Notes for the Level III Exam www.ift.world Page Managing Individual Investor Portfolios IFT Notes 8% and the applicable tax rate is 25%, the after-tax rate of return available to the investor is 6% Adjust expenses and income for inflation (if necessary) If an investor’s living expenses or salary are given as $100,000 for the current year (or “last year”) and inflation is 3%, the correct number to use when determining cash flows to calculate the return requirement for the coming year is $103,000 Adjust for liquidity events Liquidity events, which are discussed in section 4.2.1, are withdrawals that will need to be made from an investor’s portfolio in the near-term If an investor has a portfolio valued at $1,000,000 and will be making a $200,000 down payment on a home within the next months, the asset base used to determine a required return must be reduced to $800,000 Primary residence Unless told otherwise, assume that an investor’s primary residence is excluded from the investable asset base In short, to calculate the required return, (1) we use cash flow analysis, (2) determine the investible assets, (3) consider taxes to estimate an after tax return objective, and finally (4) add expected inflation to estimate the after tax nominal return objective This process is illustrated in Exhibit and Exhibit 4.1.2 Risk Objective This section addresses the risk objectives and risk tolerance aspects of LO.g: LO.h: Discuss the effects that ability and willingness to take risk have on risk tolerance The overall risk tolerance of an individual depends on both the ability to take risk and the willingness to take risk The ability to take risk involves quantitative measurement, whereas the willingness to take risk involves subjective assessment Ability to take risk:  To determine the ability to take risk we compare the size of the goals to the size of the portfolio and the time frame to achieve the goals If the investor’s goals are small compared to the investment portfolio he has a greater ability to take risk Similarly, if the investment horizon is long the investor has a greater ability to take risk  We then determine how important the goals are All else equal, the more important the goal, the lower the ability to take risk  Also we should ensure that the probability of failing to meet a high-priority objective, does not become unacceptably high This puts a limit on our ability to take risk Willingness to take risk: There are no clear rules to determine the willingness to take risk We can use psychological profiling to get estimates of an individual’s willingness to take risk However, the final IFT Notes for the Level III Exam www.ift.world Page Managing Individual Investor Portfolios IFT Notes determination is an imprecise science Sometimes, rather than accepting the client’s statement, we may need to coach them For example, when asked what he would consider to be bad portfolio performance, Peter at first answered “any loss greater than percent is unacceptable.” After being reminded of his ability to take risk, however, he revised his answer to no loss greater than 10 percent 4.2 Constraints This section addresses LO.h: LO.i: Discuss the major constraint categories included in an individual investor’s investment policy statement 4.2.1 Liquidity Liquidity measures how efficiently an investment portfolio is able to meet an investor’s anticipated and unanticipated demands for cash A portfolio’s liquidity is impacted by:  Transaction costs: These include brokerage fees, bid-ask spread etc As transaction costs increase, liquidity decreases  Price volatility: If the market for an asset is volatile, portfolio liquidity decreases because we are not certain of what cash will be realized from the sale of the asset Significant liquidity requirement can limit the ability to take risk The primary categories of liquidity requirements are:  Ongoing expenses: These include regular anticipated living costs  Emergency reserves: An emergency reserve must be maintained as a precaution against unanticipated events such as sudden unemployment or uninsured losses  Negative liquidity event: These include one time or infrequent expenses such as, significant charitable gift, anticipated home repairs etc Illiquid holdings: The IPS should specifically identify significant holdings of illiquid assets The client’s ownership of a home is generally an illiquid asset and can be noted here 4.2.2 Time Horizon When identifying an investor’s time horizon, there are two important considerations:  Short-term vs long-term  Single-stage vs multi-stage Time horizons can be considered short-term if they are less than three years and long-term if they are 15 years or more Investors, even those who have already retired, tend to have long-term time horizons because relatively few people expect to die within the next years However, while an investor’s overall IFT Notes for the Level III Exam www.ift.world Page Managing Individual Investor Portfolios IFT Notes time horizon is likely to be long-term, this may include multiple stages Life stages are associated with significant changes in circumstances Most obviously, investors enter a new stage of life when they retire Therefore, an investor who is still working has at time horizon of at least two stages (the working stage and the retirement stage) New life stages can also be triggered by significant liquidity events (either negative or positive) For example, in Practice Problem 11 (Part A), Mark and Andrea Mueller are about to enter a 5-year stage that will require them to make significant annual payments for their daughter’s education At the end of that stage, they will enter a second fiveyear stage in which they will once again be net savers A third stage will being 10 years from now, when Mark Mueller receives a trust distribution that will “materially” change his family’s financial situation In summary, it is likely that the investors you encounter on exam day will have a long-term, multi-stage time horizon 4.2.3 Taxes Tax considerations are vitally important and an advisor must consider taxes when formulating an IPS Some general classification of taxes are:  Income tax: Taxes on any form of income such as wages, rents, dividends, interest etc  Gains tax: Taxes on profits resulting from sale of assets  Wealth transfer tax: Taxes on transfer of assets through inheritance, gifts etc  Property tax: Taxes paid on the value of an asset such as real estate Taxes affect portfolio performance in two ways:  When taxes are paid at the end of the investment period, the portfolio growth is simply reduced by the amount of tax  When taxes are paid periodically throughout the investment period, portfolio growth is further reduced Refer to Exhibit which shows the comparison of a periodic tax of 25% vs a cumulative tax of 25% at the end A periodic tax significantly reduces portfolio performance as compared to a cumulative tax at the end (same tax rate) due to compounding effect We can use the following strategies to reduce the impact of taxes on portfolio performance:  Tax deferral: Minimize the impact of taxes by paying taxes at the end of the investment period instead of paying them periodically Strategies under this category include low turnover strategies and loss harvesting (realizing capital losses to offset otherwise taxable gains)  Tax avoidance: Avoid taxes legally by using tax-advantaged investment alternatives  Tax reduction: If avoiding taxes is not possible, use opportunities to reduce taxes For example, if capital gains tax are lower than income taxes, invest in low-dividend paying stocks  Wealth transfer taxes: Tax and estate planning attorneys usually handle these taxes Timing of the transfer is important For example, wealth transfer at death allows us to defer taxes for as long as possible On the other hand, an early transfer might be efficient if the recipient’s tax rate is lower than the donor’s tax rate IFT Notes for the Level III Exam www.ift.world Page Managing Individual Investor Portfolios IFT Notes 4.2.4 Legal and Regulatory Environment Following the law is highly recommended for anyone For CFA® candidates and charterholders, abiding by all applicable laws and regulations is required by Standard I(A) Therefore, legal and regulatory constraints are an important component of an investor’s IPS For exam purposes, legal and regulatory matters considerations tend to be tested in the context of the Learning Outcomes from other readings For example, the issue of whether to distribute assets into a trust or foundation is discussed in section of Estate Planning in a Global Context An additional legal consideration might be if any special obligations or constraints exist for an investor who has “insider” status with a firm (or has had such status in the past) 4.2.5 Unique Circumstances By definition, it is difficult to generalize about unique circumstances However, some issues that may be included in this section of an IPS include:  A large holding of own-company stock  A large holding of illiquid assets  A requirement to invest in a socially responsible manner (see section 5.2 of Equity Portfolio Management)  A requirement to hold a certain asset or asset class (such as the Inger’s plan to maintain a position in gold bullion currently worth €500,000) 4.2.6 Peter and Hilda Inger’s Investment Policy Statement This section addresses LO.i: LO.j: Prepare and justify and investment policy statement for an individual investor This LO is difficult to test directly, and the process of preparing and justifying an IPS for an individual investor is accomplished by mastering this reading’s other learning objectives Nevertheless, it is helpful to see the Inger’s return objectives, risk tolerance, and investment constraints laid out in a single document Additionally, it important to note that the IPS is a “living document” in the sense that it should be reviewed at regular intervals and updated as necessary to reflect changes in a client’s circumstances, market conditions, or portfolio performance and composition An Introduction to Asset Allocation Having identified an investor’s objectives and constraints, it is necessary to select an asset allocation that satisfies them 5.1 Asset Allocation Concepts This section addresses LO.j: IFT Notes for the Level III Exam www.ift.world Page 10 Managing Individual Investor Portfolios IFT Notes LO.k: Determine the strategic asset allocation that is most appropriate for an individual investor’s specific investment objectives and constraints Having created an investor’s IPS, an advisor will turn his attention to the asset allocation decision For exam purposes, this is likely to involve evaluating three to five possible portfolios, each with different allocations to various asset classes, and choosing the one that fits best within an investor’s objectives and constraints There are four steps in this process: Step 1: Eliminate allocations that not meet the investor’s real, after-tax return requirement It is obviously inappropriate to select a portfolio that does not generate sufficient returns Step 2: Eliminate allocations that fail to meet an investor’s risk tolerance, which is likely to be expressed in quantitative terms, such as standard deviation For example, an investor might say that a portfolio’s expected return must be at least two standard deviations above -10% This is another way of saying that the investor is only willing to accept a 2.5% probability of a return of -10% or worse.1 Step 3: Eliminate allocations that not meet an investor’s constraint Specifically, the allocation to cash must meet the investor’s liquidity need For example, an investor who intends to withdraw $50,000 annually from a portfolio worth $1,000,000 should have an allocation of at least 5% to cash Step 4: Evaluate remaining portfolios based on 1) risk-adjusted performance measures such as the Sharpe ratio, and 2) diversification attributes In the Susan Fairfax case discussed in this section, the two portfolios (A and E) that remain in consideration after steps through have been completed have identical Sharpe ratios of 0.574 So deciding between these two portfolios comes down to an assessment of their diversification attributes But how we know what an appropriately diversified portfolio looks like? The passage below, from section 3.2 of Estate Planning in a Global Context, offers an indication: “Several authors have examined the return-volatility trade-off on portfolio sustainability in the context of asset allocation Diversification is particularly useful in this context because it reduces volatility without necessarily decreasing return Not surprisingly, recommendations vary; but equity allocations between 30 percent and 75 percent of total portfolio value seem to maximize portfolio sustainability.” In the Susan Fairfax case, portfolio A has a 40% allocation to equities compared to portfolio E’s equity allocation of just 20% And it turns out that portfolio A is the recommended allocation for Fairfax However, as mentioned, this is only an indication and not a firm rule For example, in Practice Problem 11 (Part B), portfolio A is recommended for the Muellers despite having just a 20% allocation to equities Assuming that returns are normally distributed IFT Notes for the Level III Exam www.ift.world Page 11 Managing Individual Investor Portfolios IFT Notes 5.2 Monte Carlo Simulation in Personal Retirement Planning This section addresses LO.k: LO.l: Compare Monte Carlo and traditional deterministic approaches to retirement planning and explain the advantages of a Monte Carlo approach Deterministic models use single point estimates for inputs such as asset returns, interest rates, and inflation A good example of the traditional deterministic retirement planning process is provided in section of Lifetime Financial Advice: Human Capital, Asset Allocation, and Insurance, which makes the following assumptions:  65-year-old investor  $1 million portfolio (60% in equity mutual funds, 40% in fixed income mutual funds)  7.4% gross return (9% for equities, 5% for fixed income)  6.14% net return (after mutual fund fees of 1.26%)  3% annual inflation  $50,000 annually liquidity requirement (in real terms) If the investor wants to know whether he will run out of money before his 90th birthday, the output from the deterministic model (shown below in Exhibit 18) tells him that will not Indeed, the investor will have sufficient funds to continue making annual withdrawals until after his 95th birthday However, it is unrealistic to assume that, for example, a portfolio generate a return of exactly 7.4% every year for the next 30 years Moreover, deterministic models only produce a simple yes/no answer to questions such as whether an investor will outlive his assets There is no analysis of probabilities In short, deterministic models are based on simplistic assumptions and can only provide simple yes/no IFT Notes for the Level III Exam www.ift.world Page 12 Managing Individual Investor Portfolios IFT Notes answers By contrast, probabilistic models such as Monte Carlo analysis not assume constant (or, put differently, riskless) returns Using the same financial information presented above, it is possible to run a Monte Carlo analysis based on the assumption of average annual returns of 6.14% However, these returns are assumed to be normally distributed with a standard deviation of 13% The output from thousands of simulated trials is shown below As shown in Figure 19a (also from section of Lifetime Financial Advice: Human Capital, Asset Allocation, and Insurance), there is a 50% probability that the investor’s assets will last until just before his 95th birthday This result is similar to the single point estimate provided by the deterministic model and shown in Figure 18 However, there is a 25% probability that the investor will suffer financial ruin by age 88, and a 10% probability that he will so before age 82 Rather than providing a simple yes/no answer to the investor’s question of whether he will run out of money before his 90th birthday, the Monte Carlo analysis reveals that the probability of this happening is greater than 25 percent The investor can then consider options such as changing his portfolio’s allocation in order to reduce this probability Therefore, the primary advantage of using probabilistic models such as Monte Carlo analysis for retirement planning is that they provide a much better understanding of the trade-off between risk and return A second, and related, advantage of probabilistic models is that they allow investors to appreciate the trade-off between short-term risk and long-term financial objectives In the example discussed above, the investor may need to accept greater short-term risk by holding a higher equity allocation in order to reduce the risk of depleting his portfolio before his 90th birthday A third advantage of probabilistic models is that they are significantly better than deterministic models at modelling the effects of taxation, which is an important determinant of the returns that an investor IFT Notes for the Level III Exam www.ift.world Page 13 Managing Individual Investor Portfolios IFT Notes actually receives from his portfolio A fourth and final advantage of probabilistic models is that they provide a more realistic portrayal of returns over multiple periods, which is important because retirement planning typically involves time horizons of at least a decade When performing M0thonte Carlo analysis, it is important to avoid relying on historical data because taking data from a specific historical period may not be the most reliable indicator of what will happen in the future Rather, investors should select data inputs (and ranges) based on capital market expectations Finally, Monte Carlo analysis should simulate the performance of specific assets – not simply the performance of a general asset class Appendix A – The Inger Family Case Study Victoria Jourdan, CFA, works for an investment firm that manages private client accounts Both Jourdan and the Inger family reside in a politically stable country whose currency trades at a fixed exchange rate of 1:1 with the Euro Real GDP growth and inflation both average about percent annually, resulting in nominal annual growth of approximately percent The country in which the Ingers reside maintains a flat tax of 25 percent on all personal income and a net capital gains tax (based on the sale of price-appreciated assets) of 15 percent, with no distinction between short- and long-term holding periods Also incorporated into the tax code is a wealth transfer tax Any asset transfer between two parties, whether as a gift or family inheritance, is taxed at the flat rate of 50 percent The country maintains a national pension plan, but that plan’s long-term viability has been called into question because of an unfavorable demographic trend toward older, retirement-age recipients Public debate has grown about how to assure the financial security of future retirees, and among this debate’s chief outcomes has been the creation of self-contributory, tax-advantaged investment accounts for individuals Taxpayers may annually contribute up to €5,000 of after-tax income to a Retirement Saving Account (RSA), which they then control RSA investment returns are exempt from taxation, and participants may begin making tax-free withdrawals of any amount at age 62 The Inger Family Jourdan has been asked to manage the Inger family account, which is a new relationship for her firm Jourdan observes that the Inger family has no stated investment policy or guidelines, and she arranges for a meeting with Peter and Hilda Inger, who have been married for 37 years, plus their two children, Christa and Hans, aged 25 and 30, respectively Peter, Hilda, and Hans accept the invitation, but Christa, who currently resides a considerable distance away from her parents, cannot attend Peter Inger, 59, is a successful entrepreneur who founded a boat manufacturing business, IngerMarine, when he was 23 years old He has worked compulsively to build the company into a producer of luxury pleasure boats sold worldwide, but he is now considering a business succession plan and retirement Peter is eager to “monetize” his equity stake in IngerMarine and believes he will be able to sell his company within the next three months He is already evaluating three separate bids that indicate probable proceeds, net of taxes on gains, of approximately €55 million to the Inger family in total The IFT Notes for the Level III Exam www.ift.world Page 14 Managing Individual Investor Portfolios IFT Notes four Inger family members are the sole IngerMarine shareholders, and any sale proceeds will accrue to the four family members in proportion to their percentage ownership in IngerMarine Peter believes that everyone in his family is financially secure and wishes to preserve that security; he recognizes the family’s need for a coherent investment plan Hilda Inger, 57, comes from a wealthy family Since her marriage to Peter, she has been a housewife and mother to Christa and Hans Hilda is the beneficiary of a trust established by her family Throughout her lifetime, the trust will distribute to her an inflation-indexed annual payment (currently €75,000), which is taxed as personal income At her death, payments will stop, and the trust’s remaining assets will be transferred to a local charity Both Hans and Christa are unmarried Hans currently works as a senior vice president at IngerMarine and specializes in boat design Peter has tried to involve Christa in the family business but she has resisted, instead achieving moderate recognition and financial success as an artist Christa has a 5-yearold son, Jürgen, whom she has chosen to raise alone The meeting with Peter, Hilda, and Hans and several telephone discussions with Christa result in the following financial and personal details for the Inger family: Table Inger Family Data Income (Annual) Peter salarya €500,000 Hans salary 100,000 Hilda trust payout 75,000 Christa (art sales) 50,000 Peter Personal Assets Home (fully paid for, held jointly with Hilda) €1,200,000 IngerMarine company equityb 60,000,000 Diversified equity securities 750,000 Fixed income securities 1,000,000 Cash (money market fund) 1,000,000 Gold bullion 500,000 c RSA 50,000 Hilda Personal Assets IngerMarine company equityb €1,200,000 Hans Personal Assets Home (net of mortgage) €200,000 b IngerMarine company equity 2,400,000 Diversified equity securities 200,000 Cash (money market fund) 100,000 Christa Personal Assets IFT Notes for the Level III Exam www.ift.world Page 15 Managing Individual Investor Portfolios Income (Annual) IngerMarine company equityb Balanced mutual funds Cash (money market fund) IFT Notes €1,200,000 75,000 25,000 a Peter expects to receive a fixed annual payment of €100,000 (taxable as income) from the IngerMarine pension plan, beginning five years from now b IngerMarine equity values are pretax market values; the equity has a zero cost basis for purposes of taxation on capital gains The company stock pays no dividend c Beginning at age 62, Peter plans to take a fixed annual distribution of approximately €5,000 (tax exempt) Box Jourdan’s Findings and Personal Observations Peter Personality Peter is a perfectionist and likes to maintain control Now that he has attained financial success, he seems intent on preserving his wealth He has consistently been averse to risk, leverage, and change, both in his company and in his personal life IngerMarine has followed policies of low debt and slow growth, focusing on earnings stability Like many of his countrymen, Peter holds a portion of his liquid assets in gold bullion He believes that gold provides a viable hedge against catastrophic economic surprises and plans to maintain his current holding (€500,000) for the foreseeable future By his own admission, Peter has been slow to adopt a succession plan—he has always believed that he was the best person to run IngerMarine Although he now wants to sell IngerMarine and retire, in the past he resisted various purchase offers for the company Goals Peter wants to maintain the standard of living that he and Hilda currently enjoy In fact, he is actively investigating real estate for a second home, and he desires that the new home “make a statement.” Hilda hopes the home will ultimately be featured in a magazine and anticipates that it will cost approximately €7 million Peter also wants to get to know his grandson better Since Jürgen’s birth, Peter has been estranged from his daughter and he wants to restore the relationship He would like to provide financial support for Jürgen’s health- and education-related expenses, and he plans to begin a gifting program for Jürgen next year; the gifts will be €15,000 per year, increasing with inflation Peter has a passion for photography and anticipates purchasing a minority interest (€5 million) in Exteriors, a noted photography magazine The purchase would reflect his desire to support the magazine’s high-quality work and might also lead to a post-retirement consulting opportunity Because the investment is unlikely to produce meaningful current income, Peter does not intend to make any IFT Notes for the Level III Exam www.ift.world Page 16 Managing Individual Investor Portfolios IFT Notes additional investment in Exteriors Finally, Peter also has a strong desire to ensure his family’s financial security and feels he will have accumulated enough wealth through the sale of IngerMarine to realize this goal He does not, however, have a formal estate plan for transferring assets to his children and grandchildren Hilda Personality Hilda has intentionally removed herself from the family business She has been a major factor, however, in Peter’s decision to retire and have a second home closer to their daughter and grandson In light of the major changes about to take place, Hilda wants to become more knowledgeable and active in managing the family’s wealth Goals Hilda has a strong interest in interior design and two years ago founded a small, sole-proprietorship design company She is eager to apply her talents to designing and building the Ingers’ new home and desires complete freedom in determining the home’s interior design Her company currently operates on a breakeven basis, with revenues approximately matching expenses Hans Personality Hans appears to be somewhat of a gambler He has always felt financially secure, and is much more willing than his father Peter to engage in riskier investment opportunities He sees his father as overly conservative and believes that IngerMarine would be in a more commanding position if Peter had only leveraged the company to expand production and marketing efforts He drives a very expensive sports car Goals Hans does not want to stay in the boat business and would prefer a career that allows him more free time He has wanted to participate with college friends in various real estate projects, but his father has steadfastly refused to underwrite the investments Consistent with his attitudes about risk, Hans prefers high-return investments, believing that he has enough time in his life to recover from any occasional losses Although Hans is in no hurry to marry and have children, he believes he will ultimately so and has been looking for a new, larger home, in the €500,000 to €700,000 price range Finally, Hans is considering a minority investment (estimated to be €550,000, with no further investment planned) in a nightclub scheduled to open in his city Christa Personality Christa has been estranged from the family for several years She has resisted pressure to enter the IFT Notes for the Level III Exam www.ift.world Page 17 Managing Individual Investor Portfolios IFT Notes family business, deciding instead to pursue a career in art She has also elected to raise her son Jürgen without family support, which has created tension within the family She is very self-reliant but admits to having limited financial expertise Her relations with the family have recently improved, and she is looking forward to increased contact with her parents Goals Christa is hoping to take a more proactive role in her financial affairs She recognizes the need for a coordinated family financial plan, yet she does not wish to rely solely on the family’s wealth to provide for her son’s future She would like to move into a larger apartment that would afford her the opportunity to create a painting studio Rents are expensive, however, and she needs an assured source of income so that she may focus on her art career Summary a discuss how source of wealth, measure of wealth, and stage of life affect an individual investors’ risk tolerance; Source of wealth:  Individuals who have actively acquired wealth by assuming business or market risks (e.g entrepreneurs) tend to have a higher level of risk tolerance  Individuals who have passively acquired wealth (e.g through employment, inherited wealth, etc) tend to have lower level of risk tolerance Measure of wealth: Individuals who perceive their amount of net wealth as large (small) tend to exhibit higher (lower) risk tolerance Stage of life:  Foundation stage: Above-average risk tolerance (particularly if the individual has inherited wealth) due to young age/ long time horizon  Accumulation stage: Greater risk tolerance due to increased wealth and long time horizon  Maintenance stage (early retirement): Short time horizon and moderate to lower risk tolerance, unless spending needs relative to wealth are low b explain the role of situational and psychological profiling in understanding an individual investor’s attitude toward risk;   Situational profiling is a process of categorizing individual investors by their stage of life or by their source and measure of wealth in order to understand an investor’s basic philosophy, attitudes and preferences Psychological profiling or personality typing involves categorizing investors into specific investor type based on their risk tolerance and investment decision-making style as follows IFT Notes for the Level III Exam www.ift.world Page 18 Managing Individual Investor Portfolios More risk averse Less risk averse Decision based on thinking Methodical Individualistic IFT Notes Decision based on feeling Cautious Spontaneous c explain the influence of investor psychology on risk tolerance and investment choices;     Cautious investors are extremely sensitive to investment losses, prefer low volatility and safe investments, and are slow to make investment decisions due to fear of loss; not seek professional advice Methodical investors tend to follow a disciplined investing strategy by focusing on long-term fundamentals and prefer value-style of fund management Spontaneous investors tend to over-manage their portfolios and hence, their portfolios tend to have high turnover and high volatility; prefer riskier investments; not trust investment advice of others Individualist investors prefer to make independent investment decisions and focus on long-term investment objectives d explain potential benefits, for both clients and investment advisers, of having a formal investment policy statement; An IPS establishes the communication procedures to facilitate investors and investment advisors to be aware of the process and objectives and assures coherence between the client’s guidelines and the client’s portfolio From the client’s perspective, the benefits of an IPS include:  A better understanding of their financial situation  Increased knowledge of investment strategies and the advisor’s recommendations  The ability to take an IPS to another advisor for a second opinion or to establish a new advisory relationship From the advisor’s perspective, the benefits of an IPS include:  Creating an IPS results in a deep understanding of the client’s motivations and goals  Provides guidance for investment decision making  An advisor can refer to the guidelines set out in the IPS if asked to explain her decisions e explain the process involved in creating an investment policy statement; Steps in creating an IPS include the following: i Establish long-term goals and objectives ii Define investor’s investment time horizon iii Determine investor’s risk profile iv Establish an expected rate of return v Develop asset allocation guidelines vi Document an investment methodology f distinguish between required return and desired return and explain how these affect the individual IFT Notes for the Level III Exam www.ift.world Page 19 Managing Individual Investor Portfolios IFT Notes investor’s investment policy;    A required return is the rate of return required to achieve the investor’s primary or critical longterm financial objectives Investor’s required return is calculated based on annual spending requirements and long-term saving objectives A desired return is the rate of return required to fund a client’s secondary goals If an investor’s desired (or even required) return is unrealistic, he will need to consider one or more of the following measures:  Modifying short-term goals  Modifying risk tolerance  Deferring retirement  Accepting a lower standard of living in retirement  Increase savings by accepting a lower current standard of living  Increase savings by earning additional income g explain how to set return objectives for individual investor portfolios; Return objective:  Return rates are typically calculated by dividing the cash flows that an investor requires from his portfolio by his investible asset base  When you are provided with the current value of the investor’s portfolio (PV), the number of years until planned retirement (N), the annual contributions to or withdrawals from the portfolio (PMT), and the portfolio value required to meet the investor’s needs during retirement (FV), which allows you to solve for I/Y       Projected needs in Year n After-tax Real required return% = Net Investable Assets After-tax Nominal required return% (approx) = After-tax real required return % + Current annual inflation rate % After-tax Nominal required return% (actual) = (1 + After tax Real required return%) × (1 + Current annual Inflation rate %) – Pre-tax Nominal Required return = (Pre-tax income needed / Total investable assets) + Inflation rate% If Portfolio returns are tax-deferred: o Pre-tax projected expenditures $ = After-tax projected expenditures $ / (1 – tax rate%) o Pre-tax real required return % = Pre-tax projected expenditures $ / Total investable assets o Pre-tax nominal required return = (1 + Pre-tax real required return %) × (1 + Inflation rate%) - If Portfolio returns are NOT tax-deferred: o After-tax real required return% = After-tax projected expenditures $ / Total Investable assets o After-tax nominal required return% = (1 + After-tax real required return%) × (1 + Inflation rate%) –1 o Pre-tax Nominal required return% = After-tax nominal required return / (1 – tax rate%) h discuss the effects that ability and willingness to take risk have on risk tolerance; Risk objective: The overall risk tolerance of an individual depends on both the ability to take risk and the willingness to IFT Notes for the Level III Exam www.ift.world Page 20 Managing Individual Investor Portfolios IFT Notes take risk Overall Risk Tolerance = Minimum (Ability to take risk, Willingness to take risk) • • • • • • • • • • • Factors that impact ability to take risk Age Employability and nature of income Investment time horizon Pension eligibility Home ownership Level of debt Asset base relative to spending needs Saving habits Spending needs (liquidity requirements) and habits Major cash inflows or outflows Desire to leave an estate • • • • • • Factors that impact willingness to take risk Behavioral biases Attitude towards equity markets Planned retirement age Preference for conservative versus aggressive investing – Consider current fixed income / equity allocation Attitude towards risky activities Source of wealth – Through savings over time – Business i discuss the major constraint categories included in an individual investor’s investment policy statement; Portfolio constraints can be classified into following five categories: 1) Liquidity: Liquidity requirements include ongoing expenses, emergency reserves, and negative liquidity event (i.e significant charitable gift, anticipated home repairs etc) High (low) liquidity needs imply lower (higher) ability to take risk 2) Time horizon: Time horizons can be considered short-term if they are less than three years and long-term if they are 15 years or more The shorter the time horizon, the lower the ability to take risk  Single-stage time horizon e.g time period during retirement till death  multi-stage time horizon: Stage 1: From now till when a major liquidity is met; Stage 2: After meeting liquidity till retirement; Stage 3: Retirement 3) Taxes: Types of taxes include income tax, capital gain tax, wealth transfer tax, and property tax  When taxes are paid at the end of the investment period, the portfolio growth is simply reduced by the amount of tax When taxes are paid periodically throughout the investment period, portfolio growth is further reduced  The following strategies can be used to reduce the impact of taxes on portfolio performance: – Tax deferral: Paying taxes at the end of the investment period instead of paying them periodically – Tax avoidance: by using tax-advantaged investment alternatives – Tax reduction: use opportunities to reduce taxes 4) Legal and regulatory environment: Legal and regulatory constraints vary among countries and are not static For example, laws related to trusts etc Typically, these are more important consideration for institutional investors than for individuals 5) Unique circumstances: These include guidelines for social investing, trading restrictions, and privacy concerns IFT Notes for the Level III Exam www.ift.world Page 21 Managing Individual Investor Portfolios IFT Notes j prepare and justify an investment policy statement for an individual investor; The process of preparing and justifying an IPS for an individual investor is accomplished by mastering this reading’s other learning objectives k determine the strategic asset allocation that is most appropriate for an individual investor’s specific investment objectives and constraints; Basic process of selecting appropriate strategic asset allocation: Determine which asset allocations meet return requirement Eliminate asset allocations that fail to meet risk objectives Eliminate asset allocations that fail to meet investor constraints Select allocation that is most rewarding for client:  Evaluating the risk-adjusted performance of each asset allocation i.e select the asset allocation with highest Sharpe ratio  Evaluate the diversification attributes of each asset allocation i.e if an asset allocation contains too much (or too little) of an asset class, it should be avoided l compare Monte Carlo and traditional deterministic approaches to retirement planning and explain the advantages of a Monte Carlo approach Comparison between Monte Carlo and traditional deterministic approaches:  Both approaches employ a set of personal information i.e investor’s age, current income, etc  Deterministic forecasting approach implicitly assumes that future performance will be the same as past performance  Deterministic forecasting approach uses single point estimates of inputs i.e interest rates In contrast, Monte Carlo simulation method uses a probability distribution of possible input values instead of single point estimates  Deterministic forecasting approach generates a single number of possible investment outcomes for given objectives using single set of economic variables In contrast, Monte Carlo simulation approach generates probability distributions of investment outcomes through a large number of simulation trials, considering worst and best case scenarios Advantages of Monte Carlo simulation: Monte Carlo simulation has following advantages over deterministic approaches: More accurately portrays risk-return tradeoff Illustrates tradeoffs between short-term and long-term goals Provides more realistic modeling of taxes Better suited to assessing multi-period effects IFT Notes for the Level III Exam www.ift.world Page 22 ... an individual investor s attitude toward risk IFT Notes for the Level III Exam www .ift. world Page Managing Individual Investor Portfolios IFT Notes LO.c refers to how behavioral biases cause individuals... important determinant of the returns that an investor IFT Notes for the Level III Exam www .ift. world Page 13 Managing Individual Investor Portfolios IFT Notes actually receives from his portfolio... return and explain how these affect the individual IFT Notes for the Level III Exam www .ift. world Page 19 Managing Individual Investor Portfolios IFT Notes investor s investment policy;    A