managing investment portfolios the nine-step process chapter 14
TRANSCRIPT
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