Managing Individual Investor Portfolios

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 Inger Family

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 stake.

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.

The Inger Family

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.

The Inger Family

Situational – characterize individual investors by stage of life or by economic circumstance

◦ source of wealth

◦ measure of wealth

◦ stage of life

Profiling

Situational Profiling: Stage of Life Foundation stage:

◦ Establishes base for wealth creation (skill, education, business formation)

◦ 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

Individual Investor Life Cycle

17

19

21

23

25

27

29

31

33

35

37

39

41

43

45

47

49

51

53

55

57

59

61

63

65

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75

Net Worth

Age

Accumulation Phase

Long-term: Retirement Children’s college

Short-term: House Car

Consolidation Phase

Long-term: Retirement

Short-term:

Vacations

Children’s College

Spending Phase Gifting Phase

Long-term: Estate Planning

Short-term: Lifestyle Needs Gifts

Figure 2.1

Psychological Profiling 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)

Behavioral Finance Investment Framework 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 whole).

The Portfolio Management Process

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 performance

Policy Statement 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.

Benefits of a Formal Investment Policy Statement 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

Return Objective 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

Inflows

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

Outflows

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%

Risk Objective 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)

Taxes

Creating an Investment Policy Statement – Taxes Constraint

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 perspective

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

Effect of Tax Deferral on Investor Wealth over Time

0 10 20 30 years

8% TaxDeferred

5.76%After TaxReturn

$1,000

Investment Value

Time

$10,063

$5,365

Figure 2.5

Benefits of Tax Deferral

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

Methods of Tax Deferral

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 constraints

complete from a taxable perspective considering:◦ after-tax returns◦ tax consequences of shift from current portfolio

allocation◦ impact of future rebalancing◦ asset “location”

ie, nontaxable investments should not be “located” in tax-exempt accounts

Asset Allocation

Strategic Asset Allocation – Process of Elimination 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%

Allocation

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

Allocation

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%

Strategic Asset Allocation : Application to Fairfax Example1. Return Requirement – 3% real after-tax

return ◦ 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

Monte Carlo Approach to Retirement Planning 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 assumptions

More closely approximates likely investment outcomes

advantages to using as compared to a deterministic approach:1. more accurately portrays the risk-return tradeoff2. 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

Monte Carlo Simulation

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

Monte Carlo Simulation