Managing Individual Investor Portfolios

1. Managing Individual Investor Portfolios Chapter 2

2. The Inger Family • 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.

3. 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.

4. 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.

5. Profiling • Situational – characterize individual investors by stage of life or by economic circumstance • source of wealth • measure of wealth • stage of life

6. 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

7. Individual Investor Life Cycle Net Worth Figure 2.1 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 Age

8. 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)

9. 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).

10. 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

11. 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.

12. 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

15. 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

18. 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?

19. Taxes • 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)

21. 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

22. Effect of Tax Deferral on Investor Wealth over Time Figure 2.5 Investment Value $10,063 $5,365 $1,000 Time

23. Benefits of Tax Deferral

24. 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

29. Asset Allocation • 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

30. Strategic Asset Allocation – Process of Elimination • Selecting the most satisfactory asset allocation for an investor consists of four steps. • Determine asset allocations that meet return requirement (total, after tax return) • Eliminate allocations that fail to meet quantitative risk objectives or are inconsistent with investor risk tolerance • Eliminate allocations that fail to satisfy other investor constraints • Select from remaining allocations that which offers the best risk-adjusted performance and diversification

40. Strategic Asset Allocation : Application to Fairfax Example • Return Requirement – 3% real after-tax return • allocations A, B, D, and E meet requirement • Risk Tolerance – worst case nominal return of -10% in any 12 month period • expected return less 2 times σis good baseline – allocations A and E meet requirement • Constraints – allocations A and E meet stated constraints • Risk-Adjusted Performance and Diversification Evaluation

41. 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

42. Monte Carlo Simulation • advantages to using as compared to a deterministic approach: • more accurately portrays the risk-return tradeoff • gives information on possible tradeoff between short-term risk and the risk of not meeting a long-term goal • can capture the variety of portfolio changes that can potentially result from tax effects • better able to model the stochastic process of calculating future returns and the alternative outcomes resulting from the process

43. 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