Managing Investment Managing Investment PortfoliosPortfolios

The Nine-Step ProcessThe Nine-Step Process

Chapter 14Chapter 14

1. Understand the Client’s Goals

Need to be as clear and precise as possible

May have multiple goals & each goal may need to be defined

2. Identify a Target Rate of Return

Irreconcilable differences•Modify goals

•Save more

•Take more risk

•Delay timing of goals

•Lower withdrawal rate during retirement

3. Agree on a Time Horizon

Some goals have specific horizons•Saving for college

•Date of retirement Other goals may be vague

•Lifespan after retirement

4. Understand Client’s Tolerance for and Capacity for Risk

Risk tolerance questionnaire•No formulaic answer, but shows due

diligence

•Score is a guideline to asset allocation For some, capacity exceeds

tolerance For others, tolerance exceeds

capacity

5. Identify Asset Classes and Investment Vehicles

Number of classes varies with portfolio size

Investment vehicles•Can be specifically named securities

•Can be broader such as ETFs or index funds

6. Design the Asset Allocation

Spreadsheet•Percentage weights by category

•Expected rate of return

•Projected standard deviation of return Strategic Asset Allocation

•Set at highest level, Rarely changed

•Broad categories, Broad percentage ranges

•Used to determine portfolio’s overall level of risk

7. Write the Investment Policy Statement (IPS)

6 components:•Key Factual/account information

•Objectives, time horizon, and risk attitudes

•Permissible asset classes, constraints, and restrictions.

•The asset allocation

•Selection, monitoring, and control procedures

•Signatures

8. Select the Investments

If assets assigned to managers, follow the asset class & investment vehicle rules

If managed by planner, must be agreement as to criteria to be used

Tactical Asset Allocation•May be made for the purpose of “beating the

market,” rather than setting desired level of risk exposure, or to fine-tune risk-exposure

• May include many more asset categories

9. Monitoring, Managing, Reporting

Portfolio performance evaluation techniques discussed in course

Benchmarks Monitoring & reporting should at

times lead back to Step 1•Clients situations change (age, family,

attitude toward & capacity for risk)

MPT: Portfolio Size and Total Risk

(continued)

Impact of Portfolio Composition

A portfolio of only mutual funds•More funds appropriate if no-load than if

load For direct stock holdings:

•Fewer stocks needed if highly rated

•Fewer stocks if low beta holdings

•Fewer if restrained by industry

•Fewer if include international diversification

•More if highly concentrated (sector?)

Figure 14-4

Portfolio Rebalancing

Key issues:•How to define ranges

•When to rebalance

•How to rebalance Ranges:

•Range should depend on allocation percentage

•10% +/- 5% vs. 10% +/1%

Rebalancing Strategies

Optimal strategy depends on whether commissions are % or fixed dollar amount

If %, then rebalance to edge of range as soon as go over out of desired range

If fixed dollar amount, then •Set two ranges: optimal (outer) range &

rebalance (inner) range

•Rebalance to edge of inner range

Other Investment Issues

Investment [research] Effort Minimum Investment Size Ethical & Moral Appeal Reconciliation of optimal asset

allocation with optimal tax efficient allocation

Concentrated portfolios

Solutions to Concentrated Holdings

Easy solutions•In a qualified account

•Below cost Tough solutions

•Pay capital gains tax while it is still “cheap”

•Set up a hedge such as a “collar”•write call options, strike prices above stock price

•use proceeds to buy put options below stock price

Solutions to Concentrated Holdings

More tough solutions•Give some or all of holdings away

•Charitable Remainder Trust or Lead Trust

•Give to family members•Passes on CG taxes, but moves out of estate

•Give to someone who offers to “will” it back & lives for at least one year•Provides step-up in cost basis to market

value

Dollar Cost Averaging

Formula investment plan requiring periodic (such as monthly) fixed-dollar-amount investments

Passive form of market timing because more stock is purchased when price is low than when high.

(continued)

Dollar Cost Averaging

Most people do it as only way to access cash for investment

Not as effective as investing full amount at one time, if it is available•Lower expected return, but lower risk

•Better than plunking only in highly volatile periods

Good tool to overcome fear of investing

Dividend Reinvestment Plan

Company program that allows dividends to be reinvested in additional shares

May be sold at a discount from current market price

Can lead to a concentrated portfolio

Direct Purchase Plan

Specified amount of money is automatically applied toward purchase of company’s stock at specified intervals (such as once a month)

Form of dollar cost averaging Can lead to concentrated portfolio if

don’t change selections

Employee Stock Purchase Plans

Defined in IRC Sec. 423 Allows company to sell stock to

employees at discount from fair market price

Option to buy stock must be offered to employees on nondiscriminatory basis to receive special tax treatment

(continued)

Employee Stock Purchase Plans

Offer price can be as low as 85 percent of fair market value on either offer/grant date or on sale date, whichever is less

Benefit to employee:•Can acquire stock at below market prices

•“Forced” savings plan Drawback:

•Can lead to concentrated portfolio

Behavioral Factors Affecting Outcomes

Behavioral Finance•MPT built on the “economic man”

•In truth, people have built in irrationalities that affect decision making

Behavioral Factors Affecting Outcomes

Patterns and Predictions•People seek to see patterns

•Everyone uncomfortable with idea that events are random

•First assumption is always to extrapolate, even when unrealistic

•Hindsight bias•Most people, after an event, believe they

would have predicted the result if they had needed to

Behavioral Factors Affecting Outcomes

Overly Optimistic Individuals•Investors become more confident

toward the end of a bull market (esp. men)

•More experienced investors tend to hold more concentrated portfolios

Behavioral Factors Affecting Outcomes

Law of “Small” Numbers•People willing to extrapolate based on a

small number of observations•Many willing to base expected rates of return

on last two or three years

Framing the Plan

Framing is the manner in which an issue is presented•When presented with alternative asset

allocations, most people choose the one in the “middle”

•Gains & losses measured relative to the size of the investment (a $20 loss on a $100 investment is more painful than a $1,000 loss on a $10,000 investment!)

Framing the Plan

“1/N” approach to security selection

Mental Accounting•People tend to keep money in the

account in which it was earned, and invest according to the risk objectives of that account

Selling a Client On a Plan

Technical presentation (such as asset allocation) may leave a client cold•Telling a “story” about how portfolio will

work may convince client to do what he or she should be doing

In a retirement portfolio, distinction between “income” and “cash flow”

(continued)

Selling a Client On a Plan(continued)

Example:•Putting one year’s worth of cash withdrawals

into a MMMF for a retirement portfolio

•If market goes up, sell stock to provide cash withdrawal

•If market goes down, take withdrawal from MMMF

•Replenish MMMF in a year in which market goes up