CFA CFA level 3 CFA level 3 CFA level 3 CFA level 3 CFA volume 2 finquiz smart summary, study session 4, reading 8

2018 Study Session # 4, Reading # “MANAGING INDIVIDUAL INVESTOR PORTFOLIOS” SAA = Strategic Asset Allocation MCS = Monte Carlo Simulation CF = Cash Flow INVESTOR CHARACTERISTICS 3.1 Situational Profiling Categorizing individual investors based on their situational characteristics Investor’s basic philosophy & preferences that facilitate the discussion of investment risk with the investors Approaches of Situational Profiling 3.1.1 Source of Wealth 3.1.2 Measure of Wealth Manner of acquiring wealth offers insight into an investor’s risk attitude Active investors (e.g successful entrepreneurs) exhibit a higher level of risk tolerance Reluctant to cede control to a third party Passive recipients of wealth (e.g inherited wealth) may be associated with reduced willingness to assume risk If investor perceives his holdings as small (large), may demonstrate a low (high) tolerance for portfolio volatility Low return (high return) portfolio as compared to lifestyle is considered small (large) 3.1.3 Stage of Life i) Foundation Phase ii) Accumulation Phase Individual’s base establishment phase Long-time horizon & above avg risk tolerance Very few investable assets iii) Maintenance Phase Individual moves into the later years of life Risk tolerance & time horizon Goal ⇒ preserving wealth Income accelerates & gradually reaches its peak Risk tolerance, wealth & long-term time horizon iv) Distribution Phase Accumulated wealth is transferred to other persons or entities Tax constraints & transfer strategies often become important consideration Copyright © FinQuiz.com All rights reserved 2018 Study Session # 4, Reading # 3.2 Psychological Profiling 3.2.1 Traditional Finance 3.2.2 Behavioral Finance Investors are risk averse Investors hold rational expectations Evaluate investments in portfolio context Economic considerations Individual investors are: Loss averse Hold biased expectation Portfolio construction through pyramiding Economic & subjective considerations 3.2.3 Personality Typing Cautious Investors Methodical Investors Risk averse to potential losses Strong need for financial security Prefer low turnover & low volatility Often missed opportunities due to over analysis Undertake research on trading strategies No emotional attachments to investment positions Conservative investors Spontaneous Investors Individualistic Investors Highest portfolio turnover ratio& below avg return Quick to make investment decisions More concerned with missing an investment trend Place a great deal of faith in handwork Not afraid to exhibit investment independence in taking a course of action INVESTMENT POLICY STATEMENT A well constructed IPS: Presents the investor’s financial objectives & constraints Sets operational guidelines for constructing a portfolio Establish basis for portfolio monitoring & review Is portable & easily understandable Document that protects both the advisor & the individual investor Copyright © FinQuiz.com All rights reserved 2018 Study Session # 4, Reading # 4.1 Setting Return and Risk Objectives Required Return Desired Return Return level necessary to achieve the investor’s primary or critical long-term objectives Total return approach should be followed Generally driven by annual spending & longterm saving goals Return level associated with investor’s secondary goals When an investor’s return objectives are inconsistent with his risk tolerance, a resolution is required If portfolio’s expected return> investor’s return objective then: Assume less risk to protect the surplus Use the surplus for assuming greater risk All CFs should be treated the same way (e.g all should be after-tax) Determine the amount of investable assets: If any cash outflow in six months ⇒ PV of outflow should be subtracted from the investable assets If inflows> expenses, the additional should be added to investable assets 4.1.2 Risk Objective Ability to Take Risk Willingness to Take Risk Subject to quantitative measurement Determine the investor’s short-term & longterm financial needs & goals Determine the importance of these goals Determine the investment shortfall that investor’s portfolio can bear Important considerations are: Liquidity needs Time horizon Portfolio size Goals Subjective assessment Psychological profiling provides useful estimates of an individual’s willingness to take risk Important considerations are: Personality type Portfolio holdings Implicit or explicit statements State whether the client’s ability & willingness is below avg., “avg.” or “above avg.” Overall risk tolerance ⇒ lesser of the two if they are in conflict 4.2 Constraints 4.2.1 Liquidity Portfolio’s ability to efficiently meet an investor’s anticipated & unanticipated demands for cash distributions the liquidity needs, the investor’s ability to bear risk Copyright © FinQuiz.com All rights reserved 2018 Study Session # 4, Reading # Reasons for Liquidity Requirements Ongoing Expenses Emergency Reserves One of the portfolio’s highest priorities Should be met with liquid investments due to short time horizon Precaution against unanticipated events Reserve size ⇒ months to more than year of the client’s anticipated expenses Negative Liquidity Events For example a significant charitable gift, home repairs etc As time horizon to such events , liquidity needs Transaction costs & price volatility are two characteristics that determine a portfolio’s liquidity IPS should specifically identify significant illiquid holdings (e.g home or primary residence) Sometimes the home is treated as a long term investment used to meet long-term housing needs or estate planning goals 4.2.2 Time Horizon Long-term time horizon if > 15 or 20 years Short-term time horizon if < years Intermediate to long term if 3-15 years Time horizon can be a single stage or multistage A shift from one stage to another stage occurs when client’s objectives & constraints change 4.2.3 Taxes Widely recognized categories of taxes are: Income tax Gains tax Wealth transfer tax Property tax Different tax strategies to minimize the impact of taxes includes: Tax deferral Tax avoidance Tax reduction 4.2.4 Legal and Regulatory Environment Frequently involve taxation & the transfer of personal property ownership Prudent investor rule may apply if manager is acting in a fiduciary capacity Copyright © FinQuiz.com All rights reserved 2018 Study Session # 4, Reading # The Personal Trust Established by the grantor Funded when grantor transfers legal ownership of designated assets to the trust Two types Revocable trust ⇒ grantor retains control over assets & is responsible for any tax liability Irrevocable trust ⇒ trust is responsible for tax liability & terms of the trust are fixed 4.2.5 Unique Circumstances Might include guidelines for social or special purpose investing List of assets held outside the investment portfolio Some examples are: Concentrated position in low basis stock Significant amount of assets for charity purpose Significant unusual expenditure AN INTRODUCTION TO ASSET ALLOCATION 5.1 Asset Allocation Concepts Process of elimination is used to arrive at appropriate SAA Process of selecting most satisfactory allocation consists of the following steps: Determine the allocations that meet the investor’s return requirement Eliminate allocations that fail to meet risk objectives Eliminate asset allocations that fail to satisfy the investor’s stated constraints Evaluate the expected risk adjusted performance & diversification attributes 5.2 Monte Carlo Simulation (MCS) in Personal Retirement Planning MCS is generally superior to deterministic approach because: It incorporates path dependency effect & assumptions variability It generates probability distribution of final value rather than a single point estimate It allows projections of best & worst case scenarios It can capture the variety of portfolio changes MCS users should: Choose a simulation that simulates the performance of specific investments & takes into account the tax consequences Be aware that simulation is input dependent Drawbacks: Can be biased by the perceptions of the analyst Actual results may differ from simulated results Copyright © FinQuiz.com All rights reserved  .. .20 18 Study Session # 4, Reading # 3. 2 Psychological Profiling 3. 2. 1 Traditional Finance 3. 2. 2 Behavioral Finance Investors are risk averse Investors... individual investor Copyright © FinQuiz. com All rights reserved 20 18 Study Session # 4, Reading # 4.1 Setting Return and Risk Objectives Required Return Desired Return Return level necessary to achieve... the liquidity needs, the investor’s ability to bear risk Copyright © FinQuiz. com All rights reserved 20 18 Study Session # 4, Reading # Reasons for Liquidity Requirements Ongoing Expenses Emergency