Chapter 14

Managing Portfolios: The Practice

The Nine-Step Investment Process(1 of 2)

1. Understand the client’s goals

2. Identify a target rate of return

3. Agree on the time horizon

4. Understand the client’s tolerance for and capacity for risk

5. Define the asset classes

The Nine-Step Investment Process(2 of 2)

6. Determine an appropriate asset allocation

7. Create the Investment Policy Statement (IPS)

8. Select the investments themselves

9. Monitor and adjust as needed

Understand the Client’s Goals

• Need to be as clear and precise as possible

• May be multiple goals & each goal may need to be defined

Identify a Target Rate of Return

• Irreconcilable differences– Modify goals– Save more– Take more risk– Delay timing of goals– Lower withdrawal rate during retirement

Agree on a Time Horizon

• Some goals have specific horizons– Saving for college– Date of retirement

• Other goals may be vague– Lifespan after retirement

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

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

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

• Broad categories

• Broad percentage ranges

• Rarely changed

• Used to determine portfolio’s overall level of risk

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

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 level of risk-exposure

• Made more frequently

• May include many more asset categories

Monitoring, Managing, Reporting

• Portfolio performance evaluation techniques discussed in course

• Benchmark

• Monitoring & reporting should at times lead back to Step 1– Clients situations change (age, family, attitude

toward & capacity for risk)

Portfolio Size and Total Risk

(continued)

Portfolio Size and Total Risk (continued)

• On average, total risk of portfolio declines as additional securities added to portfolio.

• Total risk of portfolio declines at DECREASING rate as additional securities are added– Example: Addition of third security to two-security

portfolio will reduce total risk by substantially greater amount than will addition of fortieth security to 39-security portfolio.

(continued)

Portfolio Size & Total Risk (continued)

• On average, total risk of portfolio converges downward toward total risk of market portfolio.

• On average, no amount of diversification can reduce total risk of portfolio below that of market portfolio.

• The lower the commission one pays per trade, the larger the number of securities that would be optimal.

Impact of Portfolio Composition

• A portfolio of only mutual funds– More funds appropriate if no-load than if load

• For direct stock holdings:– Fewer stock needed if highly rated– Fewer stock if low beta holdings– Fewer if restrain by industry– Fewer if include international diversification– More if highly concentrated

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 Effort

• Minimum Investment Size

• Ethical & Moral Appeal

• Reconciliation of optimal asset allocation with optimal tax efficient allocation

• Concentrated portfolios

Solutions to Concentrated Holdings (1 of 2)

• 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 (2 of 2)

• 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

• Tends to “average” unit purchase cost of investment made over time

• Passive form of market timing because more stock is purchased when price is low than when high.

(continued)

Dollar Cost Averaging (continued)

• 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

• Shares often newly issued

• 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 (continued)

• 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 Finance

• MPT built on the “economic man”

• In truth, people have built in irrationalities that affect decision making

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

Overly Optimistic Individuals (1 of 2)

• Dutch auctions produce higher prices than sealed bid auctions

• When value uncertain, the most optimistic person ends up setting the price

• Nearly everyone believes they are above average (Lake Woebegone)– Successes due to skill– Failures due to bad luck

Overly Optimistic Individuals (2 of 2)

• Investors become more confident toward the end of a bull market (esp. men)

• More experienced investors tend to hold more concentrated portfolios

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 (1 of 2)

• 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 (2 of 2)

• “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