1. Sandy Warrick, CFARisk and Return for Private Investors

2. What do Private Clients Care About?

Needs

Goals

Aspirations

3. Private Investors have Needs

Needs are what they must accomplish with their investments if their investments perform poorly.

Investors should be able to achieve their goals with 95% to 99% probability.

Many investors portfoliosfell so muchfrom late 2007 to early 2009 that their needs might not be met!

Some needs can become goals when things dont go well!

4. Private Investors have Goals

Goals are what a family wants to accomplish if their investments perform as well as they expect.

Investors should be able to achieve their goals with 50% to 70% probability.

5. Private Investors have Aspirations

Aspirations are what they hope to accomplish with their investments if their investments performvery well .

Human capital (work) or entrepreneurial achievement (luck) is generally how aspirations are achieved.

Investors probably hope to achieve their aspirations with 10%-20% probability or less.

6. How Do Planners Design Portfolios for Clients?

They might use buckets for needs, goals & aspirations:

• Needs: CDs, investment grade bonds and annuities can be matched to client needs.

• Goals: A stock portfolio whose return will probably be enough to accomplish the goals.

• Employer stock options or starting your own company are usually the only way to achieve aspirations.

7. Is There a Better Way than Buckets?

I think there is: Liability Driven Investment

• Your liabilities are your needs!

• This is like what pension plans do:

• • They design their portfolios to match the payments they will need to make to retirees.

• Pensions have the advantage of having a very large risk pool private investors dont.

• How do we match your portfolio to your needs?

8. Warning: There is Math!

I apologize, but there is no way around it:

• We must do some math in order to help design suitable and optimal portfolios.

This math was developed by Jarrod Wilcox, CFA who has a Ph.D. in finance from MIT.

One of his many insights:

• The key relation is the leverage ratio.

• What is the leverage ratio?

9. Here is the Math: L :leverage. : the annualized volatility S : skewness of returnsK : kurtosis of returns 10. Leverage = Assets / (Assets Liabilities) 11. What is ?

We useto represent the portfolios risk.

is the Greek s

Investment professionals generally usevolatilityas the primary measure of risk.

A high risk portfolio decreases the probability ofbeing able to meet basic needs.

A high risk portfolio increases the amount of basic needs that cant be met.

A portfolios past risk is a reasonable estimate of future risk.

12. What is Skew?

Skew is what happens when very low probability events are actually more probable than the bell-curve predicts.

Positive Skew:

• Think of a lottery ticket. If you win, the payoff is very large and the probability, no matter how low, is higher than the bell-curve.

Negative Skew:

• Financial markets usually have negative skew: large movements are usually negative.

• Negative Skew isBAD .

13. What is Kurtosis?

Excess Kurtosis is what happens when large events, both positive and negative, are more common than the bell-curve.

The bell-curve (also known as the Gaussian or Normal distribution) has a kurtosis of 3.

Historic returns have kurtosis of between 4 and 6.

• Kurtosis above 3 isBAD .

14. Market Risk Premium: Consumption Models Economists have attempted to estimate what the market risk premiumshould beusingconsumption basedmodels. Their conclusion is that the historic risk premium is higher than it should be, Thats a puzzle The 2007-2008 might have solved the puzzle risk is higher and returns are lower when we include these years! 15. Equity Risk Premium: Consumption Models Economists sometimes call this the equity risk premium and its the same thing. Regardless of what you call it, its still a puzzle 16. The Relation between Return and Risk Another name for the equity risk premium is the market price of risk. 17. Historic Excess Returns vs. Risk Cash, Bond, Stock 1970 to 2009 18. Risk and Return

The previous slide shows that for a historic portfolio holding stocks, bonds and cash, return increased with risk.

The developers of the Capital Asset Pricing Model was awarded the Nobel Prize in Economics.

• If you can borrow at the risk-free rate (you cant, but some people can), then the relation between risk and return is a straight line.

19. A Bit More Math: Excess Return: Return higher than the risk free rate. Slope: Increased in return for an increase in risk L :leverage. : the annualized volatility S : skewness of returns.K : kurtosis of returns 20. Capital Market Assumptions

Risk Free Return = 4%

Return / Risk Slope =

Skew = -1.0

Kurtosis = 5

21. Aggressive Investor: Leverage = 1

If your leverage is equal to 1, then you dont have any financial needs and all your wealth is discretionary.

• By any definition you are a rich person.

• • Freedoms just another word for nothing left to lose?

• Our system would classify you as aggressive.

• An aggressive investor would have a very high risk tolerance and is willing to take on considerable risk in search of extra return.

22. Moderate Investor: Leverage = 2

If your leverage is equal to 2, then your financial needs (liabilities) and your discretionary wealth are equal!

• You plan to spend half your principal and income from your savings and leave the same amount in your estate.

• Our system would classify you as moderate.

• Moderate investors are typical HNW prospects and are usually the best clients for an asset manager concentrating on this market.

23. Conservative Investor: Leverage = 3

If your leverage is equal to 3, then your financial needs (liabilities) is twice your discretionary wealth!

• You plan to spend all of your dividends and income and2/3 rdof the principal, leaving 1/3 rdin your estate.

• Our system would classify you as conservative.

• There are HNW prospects and clients that are conservative, but generally this characteristic better fits the mass affluent. These are bad HNW clients because they want good results but they get upset in down markets.

24. Risk Adjusted Return vs. Risk 25. How Do We Classify Investors?

One way to do this is to figure out how much the investors family will need over the rest of their life.

This is very hard to do even if we knew how long and how healthy they would be.

Its even harder since lifespan and health cant be predicted with any accuracy.

Even more important: different families with the same liabilities have different comfort with risk.

26. We Can Use an Expert System with a Questionnaire

In this questionnaire, asset classes are ranked for suitability for every response to every question in the questionnaire.

These question measure both yourabilityand yourwillingnessto assume risk.

In this exercise, we assume that yourabilityis more thattwiceas important as yourwillingness .

27. Suitability 28. Model Portfolio Conservative Moderate Aggressive Cash 15.9% 1.2% 0.2% Bonds 58.1% 42.0% 8.3% Stock 25.4% 56.4% 84.1% Alternatives 0.7% 0.4% 7.4% Risk: 5.7% 9.7% 14.0% Return: 5.4% 6.2% 7.0% 29. Asset Allocation vs. Risk Tolerance 30. Risk vs. Return for Model Portfolios