Reading 9

Managing Individual Investor Portfolios

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Graphs, charts, tables, examples, and figures are copyright 2014, CFA Institute. Reproduced
and republished with permission from CFA Institute. All rights reserved.

Contents
1.
2.
3.
4.
5.

Introduction
Case Study
Investor Characteristics
Investment Policy Statement
An Introduction to Asset Allocation

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1. Introduction

Portfolio management of individual investors

Diversity of investor types
Learn how to create IPS of individual investors
Basics of asset allocation
Case Study Based
Almost certain to show up on your exam

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2. Case Study
Stable developed world country; Tax rate = 25%; currency pegged to euro
Wealth transfer tax = 50%
Peter
59
Entrepreneur

Hans
30
Works for Dad

Hilda
57
Housewife

Christa
25
Artist
Mother

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Jurgen
5

Family Business
IngerMarine Boat Manufacturing
Planning to sell for about Euro 55 million
Income and Assets
See Table 1

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Box 1: Jourdans Findings and Personal Observations

Personality
Perfectionist
Likes to maintain control
Risk averse

Goals
Maintain standard of living
New home that makes a statement
Euro 5 million in Exteriors (Photography)
Ensure familys financial security
No formal estate plan

Personality
Intentionally removed from family
business
Encouraged Peter to retire and get
close to Christa
Wants to become more active in
managing family wealth

Goals
Strong interest in interior design
Runs her design company
Interior design of new home

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Personality
Gambler
Sees father as too conservative
Expensive sports car

Goals
Does not want to stay in boat business
Wants career that allows more free time
High risk investments
Considering minority interest in night club
(500k)
Looking for a new home (500k 700k)

Personality
Estranged from family
Career in art
Raising son without family support
Wants to be self reliant but admits
to having limited financial expertise
Looking forward to increased
contact with parents

Goals
Wants to be more proactive in financial
affairs
Recognizes need for coordinated family
financial plan but does not want to rely
solely on family wealth
Wants to move into larger apartment with
space for painting studio (Expensive!)

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3. Investor Characteristics
Before creating IPS we should consider behavioral biases, preferences
and perceptions of risk
3.1 Situational Profiling
3.2 Psychological Profiling

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3.1 Situational Profiling

Sources of Wealth
Self-made investors familiar with risk taking, higher level of self-confidence high risk tolerance
Strong sense of personal control over risks they are taking
Reluctant to cede control
Passive investors less experience with risk generally have reduced willingness to take risk
Less confidence that they can rebuild wealth should it be lost

Measures of Wealth
Look at wealth in the context of lifestyle
Does investor perceive that wealth easily supports lifestyle?
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Stage of Life: Ability to accept risk begins high and declines with age
Foundation Phase: Young, long time horizon Above average tolerance for risk
However, many are unwilling or unable to do so (Example: Christa)
Accumulation Phase: Earnings accelerate, expenses rise too (family, home)
If spending habits dont change more savings/investment
Some might forego saving and increase expenditure on luxury goods
Generally high risk tolerance
Maintenance Phase: Focus on preserving wealth risk tolerance down
Distribution Phase: Accumulated wealth transferred to other persons or entities
Dealing with tax constraints is important

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3.2 Psychological Profiling

First part is simply an overview of what youve seen in study session 3
Exhibit 1: Risk Tolerance Questionnaire Personality Typing
Exhibit 2: Personality Types (BB&K Model)

More
Risk
Averse

Decisions based
on thinking

Decisions based
on feeling

Methodical

Cautious

Confident
Individualist

Adventurer

Careful
Less
Risk
Averse

Individualist

Spontaneous

Impetuous
Guardian

Celebrity
Anxious

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Exhibit 3: Inger Family Personality Types

Decisions based
on thinking
More
Risk
Averse

Less
Risk
Averse

Decisions based
on feeling

Methodical

Cautious

Individualist

Spontaneous

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4. Investment Policy Statement

The IPS is a client-specific summation of the circumstances, objectives,
constraints and policies that govern the relationship between advisor and
investor.
4.1 Risk and Return Objectives
4.2 Constraints
1.
2.
3.
4.
5.

Liquidity
Legal and Regulatory Environment
Time Horizon
Taxes
Unique Circumstances

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Return Objective
Return objective must be set in the context of risk constraints
Return requirement
vs.
Return desire

Return necessary to achieve primary or critical long-term obligations

Return necessary to achieve secondary goals

Historically the terms growth requirement and income requirement have been used
However, better to think in terms of total return
Learn how to calculate required return
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Study Exhibit 4 and Exhibit 5 (Very Important!)

1. Project Cash Flows

2. Investable Assets
3. After-tax return objective
4. Add expected inflation

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Risk Objective
Ability to Take Risk

Willingness to Take Risk

Quantitative Measurement
Based on financial goals, resources
and time frame
How important are the goals?
How much short-fall can be absorbed
without jeopardizing investment goals

Subjective
Psychological profiling

Exercise: What are Peter and Hildas

primary and secondary objectives? What
is their ability to take risk?

Peter: Any loss greater than 5% is

unacceptable.
What does this say about his
willingness to take risk?

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Constraints

Liquidity
Legal and Regulatory Environment
Time Horizon
Taxes
Unique Circumstances

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Liquidity
Investment portfolios ability to efficiently meet an investors anticipated and
unanticipated demands for cash distributions
A portfolios liquidity is impacted by:
1. Transaction Costs
2. Price Volatility
Significant liquidity requirements limit ability to take risk
Three primary types of liquidity requirements:
1. Ongoing Expenses
2. Emergency Reserves
3. Liquidity Events (mostly negative, but could also be positive)
Illiquid Holdings
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Time Horizon
15 years or longer Long term

3 years or shorter Short term

Single stage vs. Multi stage time horizon

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Taxes
1.

Income Tax

2.

Gains Tax

3.

Wealth Transfer Tax

4.

Property Tax

Exhibit 7: Taxes affect portfolio performance in two ways

Example A: Periodic 25% tax
Example B: 25% tax at end

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Tax Strategies Basic Principles

Tax Deferral
Loss Harvesting
Tax Avoidance (different from Tax Evasion)
Tax Reduction
Wealth Transfer Taxes

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Legal and Regulatory Environment

Generally involve taxation and transfer of personal property ownership
Personal trusts are tools for
implementing certain investment strategies

Discuss how the Ingers can use this tool

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Unique Circumstances

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IPS for Peter and Hilda Inger

Risk and
Return

Introduction
Return Objectives
Risk Objectives
Ability
Willingness

Constraints

Liquidity
Time Horizon
Taxes
Legal and Regulatory Environment
Unique Circumstances
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5. An Introduction to Asset Allocation

Return Objective
Risk Tolerance

After-tax returns
Tax consequences of shift
Rebalancing
Asset location

Asset
Allocation

Constraints

5.1 Asset Allocation Concepts

5.2 Monte Carlo Simulation in Personal Retirement Planning

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5.1 Asset Allocation Concepts

Example 1. Asset Allocation Concepts (1)

Susan Fairfax
Read case study
Calculate return requirement
Exhibit 9
Exhibit 10

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Basic process of selecting appropriate strategic asset allocation:

1. Determine which asset allocations meet return requirement
2. Eliminate asset allocations that fail to meet risk objectives
3. Eliminate asset allocations that fail to meet investor constraints
4. Select allocation that is most rewarding for client

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Example 2
Return Requirement
Consider taxes and inflation
Dealing with tax-exempt municipal bonds

Risk Tolerance
Client has stated that worst case nominal return of -10% in any
12-month period is acceptable

Read Example 3

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5.2 Monte Carlo Simulation

Monte Carlo simulation has some advantages over deterministic approaches:

1. More accurately portrays risk-return tradeoff
2. Illustrates tradeoffs between short-term and long-term goals
3. Provides more realistic modeling of taxes
4. Better suited to assessing multi-period effects

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Review learning objectives

Examples
Practice Problems

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