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Risk tolerance factors

Source of wealth - active (high risk tolerance) - passive (low risk tolerance)
Measure of wealth - perception of wealth - higher wealth higher risk tolerrance
Stage of life - older less tolerant to risk

1

4 Life stages of individuals

Foundation
Accumulation
Maintenance
Distribution

2

Traditional vs behavioral finance - 3 individuals characteristics

Risk aversion - loss aversion
Rational expectations - biased expectations
Asset integration - asset segmentation

3

Personality types

Cautious - risk averse + emotional

Methodical - risk averse + thinking

Individualistic - risk seeking + thinking

Spontaneous - risk seeking + emotional

4

IPS benefits for clients

The IPS identifies and DOCUMENTS investment OBJECTIVES and CONSTRAINTS.
The IPS is DYNAMIC ALLOWING CHAGES in objectives and/or constraints in response to changing client circumstances or capital market conditions.
The IPS is EASILY UNDERSTOOD, providing the client with the ability to bring in new managers or change managers without disruption of the investment process.
Developing the IPS should be an EDUCATIONAL EXPERIENCE for the client.
.. Clients LEARN MORE ABOUT THEMSELVES and investment decision making.
.. They are BETTER ABLE TO UNDERSTAND the manager's investment recommendations.

5

IPS benefits for advisor

Greater KNOWLEDGE of the CLIENT

GUIDANCE for investment DECISION making.

GUIDANCE for resolution of DISPUTES.
.. Signed documentation that can be used to SUPPORT THE MANGERs investment DECISIONS as well as the manager's denials of client investment requests.

6

IPS components RRTTLLU

RRTTLLU (

Return,
Risk,

Time horizon,
Taxes,

Liquidity,
Legal,

Unique).

7

RISK and RETURN objectives should be

Consistent with reasonable capital market expectations as well as the client constraints.

If there are inconsistencies, they must be resolved by working with the client.

8

Required vs desired return for IPS

Required return is what is necessary to meet high-priority or critical goals to that client. They might include living expenses, children's education, health care, et cetera.

Desired return goals will likewise depend on the client but might be things like buying a second home, world travel, et cetera.

9

Nominal required return before tax for IPS, formula...

(NOMINAL AFTERTXAX + INFLATION) / (1-taxrate)

10

Ability to take risk in decreasing if....

Shorter time horizon.
Large critical goals in relation to the size of the portfolio.
High liquidity needs.
Goals that cannot be deferred.
Situations where the portfolio is the sole source of support or an inability to replace losses in value.

11

Long term vs short term horizon in IPS (years)

Long term > 15 years
Short < 3 years

12

Liquity constraint of IPS - emergency reserve

Holding three months to one year of the annual distribution in cash reserves could be reasonable if agreed to in advance

13

IPS - home ownership

The client's ownership of a home is generally an illiquid asset and could be noted here.

Alternatively it is often recorded under unique.

14

IPS - trusts - legal constraint

If the client has or desires a trust, mention that the MANAGER MUST FOLLOW THE TRUST DOCUMENT.

Some types of trusts specify paying all income to the income beneficiaries during their lifetimes and then distributing assets to remaindermen at the death of the income beneficiaries. This can require the manager to BALANCE THE COMPETING INTERESTS (income versus capital appreciation) of the two groups. You should mention this if it comes up.

15

Unique circumstances contraint IPS, examples

Special investment concerns (e.g., socially responsible investing).
Special instructions (e.g., gradually liquidate a holding over a period of time).
Restrictions on the sale of assets (e.g., a large holding of a single stock).
Asset classes the client specifically forbids or limits based on past experience (i.e., position limits on asset classes or totally disallowed asset classes).
Assets held outside the investable portfolio (e.g., a primary or secondary residence).
Desired bequests (e.g., the client intends to leave his home or a given amount of wealth to children, other individuals, or charity).
Desired objectives not attainable due to time horizon or current wealth.

16

Legal/regulatory constraint when planning annual gifts to children

Expert legal and tax advice regarding her annual gifts to son and plans after death are appropriate

17

Monte carlo benefits

It considers path dependency.

It can more clearly display tradeoffs of risk and return.

Properly modeled tax analysis, which considers the actual tax rates of the investor as well as tax location of the assets (held in taxable or tax-deferred locations), can be assessed.

A clearer understanding of short-term and long-term risk can be gained.

It is superior in assessing multi-period effects.

Points along the timeline can be considered to answer questions, such as, "Do savings need to be increased?" "Can I retire earlier?" "Must I retire later?"
-------
Probabilistic forecasts give both the client and manager a better indication of the risk/return tradeoff in investment decisions.

Monte Carlo simulations explicitly show the tradeoffs of short-term risks and the risks of not meeting goals.

Monte Carlo is better able to incorporate tax nuances.

Monte Carlo can better model the complications associated with future returns by more effectively incorporating the compounding effect of reinvestment.

18

Monte carlo negatives

Simplistic use of historical data, such as expected returns, for the inputs. Returns change and have a major effect on projected future values of the portfolio.

Models that simulate the return of asset classes but not the actual assets held. Simulating the return of the Wilshire 5000 when a fund with fees will be held could significantly overstate the future value or time period over which distributions can be sustained. Real assets have expenses.

Tax modeling that is simplistic and not tailored to the investor's situation.

19

Situational profiling

places individuals into categories according to stage of life or economic circumstances.

20

Psychological profiling assumes

assumes investors exhibit psychological characteristics such as loss aversion, biased expectations, and asset segregation.

21

A personality typing questionnaire attempts to

to assign the client along two dimensions: ( 1 ) risk attitudes and (2) decision-making style.

22

Cmmon time horizon constraint IPS

Long-term time horizon with two stages: 'x" years to retirement and retirement of 20-25 years.

23

IPS

document that is developed as the result of a client interview to determine their
- risk (ability and willingness) and
- return objectives and the
- five constraints, which consist of the time horizon, unique circumstances, taxes, legal and regulatory, and liquidity constraints.

24

Deterministic vs probabilistic

Generates one number while monte carlo as probabilistic method determines also probabilities of various scenarios

25

Source of wealth indicates

Knowledge and experience with risk risk taking activities.

26

7 tax regimes

Common Progressive . Progressive. Fav interest, divident, capgins

Heavy Dividend Tax . Progressive. Fav int, capgains

Heavy Capital Gain Tax . Progressive. Fav div, int

Heavy Interest Tax . Progressive. Fav div, capgain

Light Capital Gain Tax. Progressive. Fav capgain

Flat and Light. Flat. Fav div, int, capgain

Flat and Heavy. Flat. Fav int?

27

Tax drag, 3 notes for ACCRUAL TAXES

Tax drag > tax rate.
As investment horizon increases ::::} tax drag $ and tax drag o/o increase.
As investment return increases ::::} tax drag $ and tax drag o/o increase.

28

Deferred capital gain taxes

FVIFcapital gains = ( (1+ R )^N*(1-Tcg) + Tcg)

Future value interestw factor

Tcg added back to avoid taxation of initial investment

29

Tax drag, DEFERRAL BASIS , 5 notes

Tax drag o/o = tax rate.
As the investment horizon increases . tax drag is unchanged.
As the investment return increases . tax drag is unchanged.
As investment horizon increases . value of the tax deferral increases.
As investment return increases . value of the tax deferral increases.

30

FVIFcapital gains (MV <> cost basis)

FVIFcapital gains (MV <> cost basis) = (1+ R )^N*(1-Tcg) + Tcg*Basis

Basis = Cost basis / Market Value

Tcg is added back to prevent taxation of the cost basis share of inital investment.

31

FVIF (wealth tax) =

FVIF (wealth tax) = [ (1-Tw)*(1+R) ]^N

32

Tax drag ... Wealth tax vs Accrual tax

As with accrual taxes, tax drag $ and tax drag % increase with investment horizon.
!!!!! Unlike accrual taxes, when investment return increases, tax drag % decreases.

33

Wealth taxes. Tax drag 3 notes

Tax drag o/o > tax rate.

As investment horizon increases => tax drag% / $ increase.
As investment return increases => tax drag $ increases; tax drag % decreases.

34

Realized tax rate . Div int capgain.

Pint*Tint + Pdiv*Tdiv + Pcapgain*Trealizedcapgain
P = proportion of type of income in total income.
IMPORTANT !!!! just realized capgains used.

35

R.art
Return after realized taxes

R.art
Return after realized taxes = R * (1-portionInt*Tint - portionDiv*Tdiv - portionRealizedCapgain*Tcapgain)

36

Tecg . Effective capital gains tax

Tecg = Tcg * (1-(Pint+Pdiv+Pcg)) / ( 1- (Pint*Tint + Pdiv*Tdiv + Pcg*Tcg))
P = propotion of type of income in total income

Effective capital gains tax rate Tecg = capital gain tax rate * unrealized capital gain rate / net after taxes on realized income

37

FVIF all realized and unrealized taxes

FVIF all taxes = (1 + Rart)^N*(1-Tecg)+ Tecg - Tcg*(1-B)

Rart = return after realized taxes.

38

FVIF tda . Future value interest factor for tax deferred accounts

(1+r)^n * (1-t)

Plase note there is no cost basis adjustment because in these accounts funds are being debited pretax.

39

Investor's after tax risk

Standard deviation * ( 1-T )

40

What accounts to use for bonds vs stocks in terms of taxation

Stocks have little income and deferred cap gain. Use taxable accounts.

Fixed income. Opposite. Use tax deferred or exempt accounts.

41

Four types fo equity investors

Traders - forgo tax advantages due to short term trading.
Active - many gains are long term. Taxed at lower rates.
Passive - all gains long term. Taxed at preferred rate.
Exempt.

42

Accrual equivalent tax rate

Makes pretax return (R) equal to accrual equivalent after tax return (R.ae)

R.at = R (1- T.ae)

43

Accrual expuivalent after tax return (R.ae)

R.ae = N root of (FVt / PV) -1

44

Tax alpha

Vlue created by efficient tax management

45

Tax rdag

Pretax RETURN vs Aftertax RETURN
Do not confuse RETURN with FV

46

Probate

LEGAL PROCESS AFTER DEATH, during which a court determines the validity of the decedent's will, inventories the decedent's property, resolves any claims against the decedent, and distributes remaining property according to the will.

47

Estate taxes paid by

Grantor or transferor

48

Inheritance taxes paid by

Recipient

49

Under community property spouse receives

Half of marital property ( i.e. less than total estate )

50

Under forced heirship rule spouse (kids) receives

30% (30) of total estate.

51

If both community property and forced heirship rights are applicable, spouse receives

The highest from community or forced heirshp

52

Probability of joint survival

prob (joint survival ) = prob ( husband survives ) + prob (wife survives ) - prob (husband survives ) X prob ( wife survives)

53

Value accumulation from gift with taxes PAID by donor

FV = PV (1-Tg+. Tg*Te. )*(1+R*(1-Tinv)

Tg*Te is added back due to Donor not recipient paying the gift tax.

54

Future value of a gift to charity

FVcharicablegift = (1 + Rg)^N + Toi [1 + Re (1 - Tie )^N * (1 - Te )

where:

Rg = expected return on the assets in the charity's portfolio
Toi = tax rate on ordinary income
Re = expected return on the assets in the donor's portfolio
tie = donor's tax rate on investment income
Te = estate tax rate

55

Trustee vs settlor

Settlor creates trust
Trustee is beneficiary of trust

56

Taxation, credit method

Tax paid on foreign income to foreign country, and
Also tax may be paid to residence country if residence tax on foreign income is higher than foreign country's tax rate.

57

Resource residence conflict ~ taxes - solutions

Credit
Exemption
Deduction

58

Foreign income tax - deduction method

Tdeduction = Tresidence + Tsource(1-Tresidence). As in books
Or similar = Tsource + Tresidenc(1-Tsource)

59

Skipping a generation increases the value of the gift by a factor of

1/(1-t)

60

primary objectives of estate planning are to

. minimize taxes and to

. facilitate the tax­ efficient transfer of assets to heirs or recipients of charitable bequests

61

Four levels of taxation

Income, wealth, spending, transfers

62

Tax free transfer of assets to spouse...

DEFERS taxes until death of the second spouse.

63

The two primary ways of transferring ownership of assets are

lifetime gratuitous transfers (i.e., gifts) and

testamentary gratuitous transfers (i.e., bequests).

64

Excess capital represents assets

above and beyond CORE capital that can be safely transferred without jeopardizing the first generation’s lifestyle.

65

Probate can be avoided

probate can be avoided or its impact limited by holding assets in

joint ownership (e.g., joint tenancy with right of survivorship),
living trusts,
retirement plans, or
life insurance strategies.

66

Individuals can attempt to reduce or avoid forced heirship by:


■ moving assets into an offshore trust governed by a different jurisdiction;
■ gifting or donating assets to others during their lifetime to reduce the value of the final estate upon death; or
■ purchasing life insurance, which can move assets outside of realm of forced heirship provisions.
Such strategies, however, may be subject to “clawback” provisions that provide a basis for heirs to challenge these solutions in court.

67

Source tax system:

A jurisdiction that imposes tax on an individual’s income that is sourced in the jurisdiction.

68

Residence tax system:

A jurisdiction that imposes a tax on an individual’s income based on residency whereby all income (domestic and foreign sourced) is subject to taxation.

69

Source source conflict

The residence country A may claim foreign investments were manager from country A.

70

Stages of equity holding life

(1) the entrepreneurial stage,
(2) the executive stage, and
(3) the investor stage

71

Cost basis, diversification techniques

Sale
Exchange funds . Private or public
Completion portfolios
Hedging

72

Cost basis - sale - adv/disadv

ADV
Simple.
Non-systematic risk of the position is completely eliminated for shares sold.
Proceeds can be reinvested or distributed as desired.

DISADV
Most costly from a tax standpoint.
Usually requires that shares are publicly traded.
Taxes due on sale reduce the size of the invested portfolio.

73

Cost basis. Public Exchange funds

ADV
Can facilitate monetization (borrowing) through risk reduction.
Investor holds diversified portfolio, without recognizing capital gains.

DISADV
Management fees.
Must remain in the fund for a minimum period.
Cannot determine or adjust holdings.
Must hold min 20% in illiquid assets.
Unrealized tax liability remains in place.

74

Cost basis. Private exchange funds.

ADV
Can facilitate monetization (borrowing) through risk reduction.
Provides the ability to utilize hedging techniques.
Not required to hold illiquid assets.
Can adjust holding and diversification strategies.

DISADV
Management fees.
Must remain in the fund for a minimum period.
Must find outside, unrelated party willing to purchase the security and join the partnership.
Unrealized tax liability remains in place.

75

Cost basis. Completion portfolios

ADV
Investor builds a diversified portfolio over time.
Can provide cash and avoid capital gains to the extent of loss harvesting.

DISADV
Investor must have other assets.
May take substantial time to effect proper diversification.
Unrealized tax liability remains in place.

76

Cost basis. Hedging.

ADV
Fast.
Can facilitate monetization through risk reduction.

DISADV
Upside potential typically limited after hedge is in place.
Potential regulatory risk (constructive sale provision).
Unrealized tax liability remains in place.

77

Entrepreneurs and top executives frequently feel

psychologically ATTACHED to the single stock (i.e., the firm) and are therefore RELUCTANT to sell in order to achieve diversification.... In contrast to investor.

78

Risks at various equity life holding phases

Entrepreneurial - systematic, nonsystematic, liquidity
Executive - systematic, nonsystematic
Investor. - systematic and a portion of nonsystematic as he is diversifying

79

Completion portfolios is slowest diversification methods because

because sales of concentrated holding requires the ability to harvest offsetting losses on the holdings in the completion portfolio.

80

Human capital is

PV of the individual's future earnings.

81

Human capital is subject to

Earnings risk. Can be reduced by saving more, investing in assets less correlated to financial capital

82

Reducing mortality and longevity risks

Mortality - life insurance. longevity - annuities.

83

The higher risk of human capital, the ? Need in lifeinsurance

Less

84

The larger and more important the post-death objectives are to a given individual,

the greater the need for life insurance to fund those objectives that continue beyond premature death.

85

Demand for life insurance increases if

HC has low risk
Importance of meeting post death objectives is high
The higher is the weight of human capital

86

Three risks jeopardizing desired lifestyle

Financial market risk
Longevity risk
Savings risk

87

Best way to mitigate earnings risk

Lower correlation between human and financial capital