CFA CFA level 3 CFA level 3 CFA level 3 CFA level 3 CFA volume 2 finquiz smart summary, study session 4, reading 8

2018 Study Session # 4, Reading # 8

“MANAGING INDIVIDUAL INVESTOR PORTFOLIOS”
SAA = Strategic Asset Allocation
MCS = Monte Carlo Simulation

CF = Cash Flow

3. INVESTOR CHARACTERISTICS

3.1 Situational Profiling

Categorizing individual investors based on their situational
characteristics.
Investor’s basic philosophy & preferences that facilitate the
discussion of investment risk with the investors.

Approaches of Situational Profiling

3.1.1 Source of Wealth

3.1.2 Measure of Wealth

Manner of acquiring wealth offers insight into an investor’s
risk attitude.
Active investors (e.g. successful entrepreneurs) exhibit a
higher level of risk tolerance.
Reluctant to cede control to a third party.
Passive recipients of wealth (e.g. inherited wealth) may be
associated with reduced willingness to assume risk.

If investor perceives his holdings as small (large), may
demonstrate a low (high) tolerance for portfolio volatility.
Low return (high return) portfolio as compared to lifestyle is
considered small (large).

3.1.3 Stage of Life

i) Foundation Phase

ii) Accumulation Phase

Individual’s base establishment
phase.
Long-time horizon & above avg.
risk tolerance.
Very few investable assets.

iii) Maintenance Phase

Individual moves into the later
years of life.
Risk tolerance & time horizon.
Goal ⇒ preserving wealth.

Income accelerates & gradually
reaches its peak.
Risk tolerance, wealth &
long-term time horizon.

iv) Distribution Phase

Accumulated wealth is
transferred to other persons or
entities.
Tax constraints & transfer
strategies often become
important consideration.

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2018 Study Session # 4, Reading # 8

3.2 Psychological Profiling

3.2.1 Traditional Finance

3.2.2 Behavioral Finance

Investors are risk averse.
Investors hold rational
expectations.
Evaluate investments in portfolio
context.
Economic considerations.

Individual investors are:
Loss averse.
Hold biased expectation.
Portfolio construction

through pyramiding.
Economic & subjective
considerations.

3.2.3 Personality Typing

Cautious Investors

Methodical Investors

Risk averse to potential losses.
Strong need for financial security.
Prefer low turnover & low volatility.
Often missed opportunities due to over
analysis.

Undertake research on trading strategies.
No emotional attachments to investment
positions.
Conservative investors.

Spontaneous Investors

Individualistic Investors

Highest portfolio turnover ratio& below avg.
return.
Quick to make investment decisions.
More concerned with missing an investment
trend.

Place a great deal of faith in handwork.
Not afraid to exhibit investment independence
in taking a course of action.

4. INVESTMENT POLICY STATEMENT

A well constructed IPS:
Presents the investor’s financial objectives & constraints.
Sets operational guidelines for constructing a portfolio.
Establish basis for portfolio monitoring & review.
Is portable & easily understandable.
Document that protects both the advisor & the individual
investor.

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2018 Study Session # 4, Reading # 8

4.1 Setting Return and Risk Objectives

Required Return

Desired Return

Return level necessary to achieve the
investor’s primary or critical long-term
objectives.
Total return approach should be followed.

Generally driven by annual spending & longterm saving goals.

Return level associated with investor’s secondary
goals.

When an investor’s return objectives are inconsistent with his risk tolerance, a
resolution is required.
If portfolio’s expected return> investor’s return objective then:
Assume less risk to protect the surplus.
Use the surplus for assuming greater risk.
All CFs should be treated the same way (e.g. all should be after-tax).
Determine the amount of investable assets:
If any cash outflow in six months ⇒ PV of outflow should be subtracted
from the investable assets.
If inflows> expenses, the additional should be added to investable assets.

4.1.2 Risk Objective

Ability to Take Risk

Willingness to Take Risk

Subject to quantitative measurement.
Determine the investor’s short-term & longterm financial needs & goals.
Determine the importance of these goals.
Determine the investment shortfall that
investor’s portfolio can bear.
Important considerations are:
Liquidity needs.
Time horizon.

Portfolio size.
Goals.

Subjective assessment.
Psychological profiling provides useful
estimates of an individual’s willingness to take
risk.
Important considerations are:
Personality type.
Portfolio holdings.
Implicit or explicit statements.

State whether the client’s ability & willingness is below avg.,
“avg.” or “above avg.”.
Overall risk tolerance ⇒ lesser of the two if they are in conflict.

4.2 Constraints

4.2.1 Liquidity

Portfolio’s ability to efficiently meet an investor’s anticipated &
unanticipated demands for cash distributions.
the liquidity needs, the investor’s ability to bear risk.

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2018 Study Session # 4, Reading # 8

Reasons for Liquidity Requirements

Ongoing Expenses

Emergency Reserves

One of the portfolio’s highest priorities.
Should be met with liquid investments due to
short time horizon.

Precaution against unanticipated events.
Reserve size ⇒ 3 months to more than 1 year
of the client’s anticipated expenses.

Negative Liquidity Events

For example a significant charitable gift, home repairs etc.
As time horizon to such events , liquidity needs .
Transaction costs & price volatility are two characteristics that
determine a portfolio’s liquidity.
IPS should specifically identify significant illiquid holdings (e.g.
home or primary residence).
Sometimes the home is treated as a long term investment
used to meet long-term housing needs or estate planning
goals.

4.2.2 Time Horizon

Long-term time horizon if > 15 or 20 years.
Short-term time horizon if < 3 years.
Intermediate to long term if 3-15 years.

Time horizon can be a single stage or multistage.
A shift from one stage to another stage occurs when client’s
objectives & constraints change.

4.2.3 Taxes

Widely recognized categories of taxes are:
Income tax.
Gains tax.
Wealth transfer tax.
Property tax.
Different tax strategies to minimize the impact of taxes includes:
Tax deferral.
Tax avoidance.
Tax reduction.

4.2.4 Legal and Regulatory Environment

Frequently involve taxation & the transfer of personal property
ownership.
Prudent investor rule may apply if manager is acting in a
fiduciary capacity.

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2018 Study Session # 4, Reading # 8

The Personal Trust

Established by the grantor.
Funded when grantor transfers legal ownership of designated
assets to the trust.
Two types.
Revocable trust ⇒ grantor retains control over assets & is
responsible for any tax liability.
Irrevocable trust ⇒ trust is responsible for tax liability &
terms of the trust are fixed.

4.2.5 Unique Circumstances

Might include guidelines for social or special purpose investing.
List of assets held outside the investment portfolio.
Some examples are:
Concentrated position in low basis stock.
Significant amount of assets for charity purpose.
Significant unusual expenditure.

5. AN INTRODUCTION TO ASSET ALLOCATION

5.1 Asset Allocation Concepts

Process of elimination is used to arrive at appropriate SAA.
Process of selecting most satisfactory allocation consists of the
following steps:
Determine the allocations that meet the investor’s return
requirement.
Eliminate allocations that fail to meet risk objectives.
Eliminate asset allocations that fail to satisfy the investor’s stated
constraints.

Evaluate the expected risk adjusted performance & diversification
attributes.

5.2 Monte Carlo Simulation (MCS) in Personal Retirement Planning

MCS is generally superior to deterministic approach because:
It incorporates path dependency effect & assumptions variability.
It generates probability distribution of final value rather than a
single point estimate.
It allows projections of best & worst case scenarios.
It can capture the variety of portfolio changes.
MCS users should:
Choose a simulation that simulates the performance of specific
investments & takes into account the tax consequences.
Be aware that simulation is input dependent.
Drawbacks:
Can be biased by the perceptions of the analyst.
Actual results may differ from simulated results.

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