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241 Cards in this Set
- Front
- Back
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Heuristic Learning Process
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Process by which people develop investment decision making rules through experiement, trial and error, or personal experience.
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Name the four heuristic driven biases
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Representativeness
Overconfidence Anchoring and Adjustment Aversion to Ambiguity |
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Representativeness
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A heuristic process by which investors base expectations upon past experience, applying stereotypes
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Overconfidence
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People tend to place too much confidence in their ability to predict which can lead to surprises
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Anchoring and Adjustment
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The inability to fully incorporate the impact of new information on projections (i.e., conservatism)
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Aversion to Ambiguity
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Fear of the unknown. Many investors are hesitant to take positions in investments that have unknown probability outcomes
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Loss Aversion
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An individual's reluctance to accept a loss. An individual holds on to a stock hoping it will recover. Gambler keeps throwing the dice hoping to break even. Can lead to risk seeking behavior
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Frame Dependence
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Individuals make decisions and take actions according to the framework within information is received (i.e., the media) or the individual's circumstances at the time (emotional state)
Also refers to investors' tendency to change (Frame) their risk tolerance according to the direction of the market |
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Self Control
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Related to frame dependence -stage of life and dividends. A younger affluent investor avoids high dividend paying stocks but a retired investor uses them to avoid spending capital
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Regret
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The feeling (in hindsight) associated with making a bad decision
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Regret leads to what two things
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(1) staying in comfortable investments such as stocks and bonds - lack of variety in investments
(2) Use cash flows for living expenses rather than sell potentially profitable investments |
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Money illusion
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Refers to the way individuals react to inflation and its impact on investment performance. Leads to positive reactions to high returns no matter what the level of inflation and real return
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Market efficiency
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Assumes all investors have the same information, interpret it the same and make the same forecasts. Implies that all assets are priced efficiently
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What behavorial finance traits can lead to inefficiently priced stocks?
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Representativeness
Conservatism (Anchoring and Adjustment) Frame Dependence Overconfidence |
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How does representativeness lead to mispriced stocks?
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Assuming a good announcement implies good future performance (a winner) investors buy the stock and push its price up. Likewise, a bad earnings announcement (a loser) may be met with selling pressure which pushes the price down. The result is that underpriced "losers" will tend to outperform while overpriced "winners" will underperform as their prices return to their intrinsic values
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How does conservatism lead to mispriced stocks?
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Negative adjustments in price forecasts tend to be followed by negative surprises. Positive adjustments are followed by positive surprises.
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How does frame dependence lead to mispriced stocks
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Loss aversion predicts investors will be hesitant to enter the market when it is flat or falling. When the market is upward trending, investors jump in further pushing prices up.
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What are the implications of overconfidence when trading?
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1) Investors don't realize they do not have all the necessary information to form unbiased projections.
2) Investors tend to trade more frequently than can be justified by the information |
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What are the two emotions that drive individual investor attitudes toward investing?
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Fear and hope
Fear - focus on the downside. Leads to individuals striving for security. Hope - focus on potential gains - drives aspirations Hope and fear drive investor's tolerance for risk which in turn affects the way they structure their portfolios |
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Bottom layer of pyramid - what kind of investments for what kind of goals?
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secure investments - bonds and money market securities - used to fund important goals (necessities). Security. As you go up the pyramid, you have potential and aspiration.
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Optimism
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Trait of individuals who feel the odds of something bad occuring in their lives are very low or even nonexistent.
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Optimism leads to...
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Overconfidence
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Overconfidence
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The belief that one can interpret information better than the average investor and thus select superior investments.
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Overconfidence leads to....
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excessive trading
undiversified portfolios false belief of high gains with little risk high transactions costs reduced returns net return less than that of an indexed portfolio |
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Bounded rationality
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The process of making decisions with a combination of mean-variance analysis and heuristics - often applies with DC plan participants
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Limited knowledge
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refers to the failure of DC pension plan participants to utilize portfolio theory. Many just don't understand the basics of investing and can't or won't take the time to learn them.
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Bounded self-control and self-interest
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Refers to the DC plan participant taking action that is not in his or her best interest even if he or she has the knowledge and the rationality to know better
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What traits often lead DC plan participants to construct inefficient investment portfolios?
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Limited Participant knowledge
Bounds to rationality, self-control, and self-interest |
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Status quo bias
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DC plan participants' tendence to make an original allocation and not change it
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Myopic loss aversion
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Investors' focus on short-term performance and their aversion to losses
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1/n diversification
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Plan participants allocate equal amounts to the n investment alternatives
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Endorsement effect
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The misconception by plan participants that, by providing a list of investment alternatives, the sponsor is implicitly endorsing them as good investments.
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What are the factors that lead to DC plan participants holding excess amounts of their own company stock in their plan?
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Stock ownership plans can be seen as an endorsement of the stock as a good investment
Familiarity |
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Familiarity
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Individual investors tend to invest in stocks in which they are comfortable
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What is the primary factor leading to overconfidence in professionals?
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illusion of knowledge (education or experience)
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Illusion of knowledge
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Professionals feel their forecasts are based on skill so when their forecasts are inaccurate the blame is usually placed on an outside factor.
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Name the five common ego defense mechanisms.
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Ceteris Peribus
If Only Almost Right Hasn't Happened Yet Single Predictor |
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If-Only Defense Mechanism
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Forecasts are off because the analyst built the value of an economic factor into the model and the value unexpectedly changed - the analyst expected one thing and another happened
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Ceteris-Paribus Defense Mechanism
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An unexpected change in a variable that wasn't even considered by the analyst (earthquake)
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Almost Right Defense
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The forecast was close, wasn't it? it almost happened
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It hasn't happened yet defense
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Although it hasn't happened yet, it eventually will
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Single Predictor Defense
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So something went wrong with this forecast. That doesn't mean all my forecasts are inaccurate
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Why may forecasts continue to be used when previous forecasts have been inaccurate?
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A form of anchoring - even faced with poor forecasting, investors want to base investment decisions on some forecast.
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Anchoring (in the context of forecasting)
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The need to grab onto anything when faced with uncertainty
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Characteristics of Acute Market Inefficiencies
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Very transient in nature
Relatively easily identified Can be exploited using an arbitrage strategy Any uncertainty can usually be hedged away |
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Characteristics of Chronic Market Inefficiencies
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Harder to identify
Longer term in nature Resistent to investor strategies that focus on identiying mispricings and their subsequent corrections |
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Name the behavioral factors that may give rise to chronic market inefficiencies
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Herding
Rigid Views Price target revisions Correlating emotions with the market |
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Herding
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aka convoy behavior
Investors may be influenced by the masses and, as a result will keep their investment decisions in line with the rest of their peer group. |
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Rigid Views
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aka Bayesian rigidity. Investors hold onto their old views despite the presence of new information
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Price target revisions
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After purchasing a security an investor may set a price target (max expected price) for that security. When the security's price moves toward the target, the investor becomes overconfident in her investment abilities and may revise the original price target upwards and even purchase additional shares. Could expose the investor to increased risk.
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Correlating emotions with the market
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aka the ebullience cycle. In a downward market, investors may be disinclinced to evaluate their portfolio's performance. In an up market, investors exhibit exuberance and become too active with their positions resulting in investments that are too aggressive.
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Holders
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Tend not to adjust their portfolio allocations with changes in equity values
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What effect do holders tend to have on market movements
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Generally little impact
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Rebalancers
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Rigid portfolio allocations. Any deviation from the target allocation results in rebalancing back to the original weights. They buy as the market falls and sell as the market rises
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What effect to rebalancers have on market movements?
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Tend to smooth market movements.
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Valuators
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Base their rebalancing decisions on whether the market is cheap or rich
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Shifters
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Typically rebalance their portfolios in response to some non-market value related event. Institutional investors are much less prone to be shifters. Ex: After a layoff, investor shifts all his assets into low-risk, fixed income.
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What effect do shifters have on market movements?
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Tend to exacerbate market movements because their actions correspond to the direction of the market
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Formulaic rebalancing
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Setting an optimal asset allocation and reblancing the portfolio back to the target weights after the portfolio deviates from its initial allocation
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Rebalancing using judgemental flexibility
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Can be conducted when a portfolio allocation is allowed to change with fluctuating market conditions
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The manner in which an investor acquired wealth affects the investor's stance on.....
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Risk
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What type of investors are usually more risk tolerant (based on source of wealth)
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Entrepreneurs - usually more investor knowledge and experience with risk taking decisions
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What kind of investors are usually less risk tolerant (based on source of wealth)
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Investors who have received inheritances
Investors who have received one-time windfalls Wealth accumulated over a long period of secure employment All may indicate less familiarity with risk-taking activity |
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What is the relationship between perception of portfolio size and level of risk tolerance
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Positively correlated
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What are the two important factors when evaluating measure of wealth for risk tolerance?
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Perception of wealth AND
If the portfolio generates a substantial amount of funds relative to those needed to support lifestyle activities |
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What is the relationship between age and risk tolerance
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Generally, inverse
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Situational profiling
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places individuals into categories according to stage of life or economic circumstances
Due to an almost infinite number of individual circumstances, caution should be applied with categorizing individual investors with broad situational profiles. Should be considered a first step in understanding: individual preferences economic situation goals and desires Starting points include: investigating an investors's source of wealth, meausre of wealth, and stage of life |
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Psychological profiling
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assumes investors exhibit psychological characteristcs such as loss aversion, biased expectations, and asset segregation
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Traditional finance assumes investors exhibit what three major characteristics
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Risk Aversion
Rational Expectations Asset Integration |
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Risk Aversion
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Investors minimize risk for a given level of return or maximize return for a given level of risk
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Rational expectations
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investors' forecasts properly reflect all relevant information pertaining to security valuation
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Asset integration
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Investors focus not only on an individual asset's risk/return characteristics but also on how that asset interacts with (correlates with) the assets in the portfolio
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Behavioral finance assumes investors exhibit what three psychological characteristics
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Loss Aversion
Biased Expectations Asset Segregation |
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Loss Aversion
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Investors tend to prefer larger uncertain losses to smaller certain losses.
leads to investors holding losing investments too long. Related to fear of regret |
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Biased Expectations
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Investors have too much confidence in their ability to forecast the future. Tend to ignore or discount information not supporting their choices
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Asset Segregation
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Instead of evaluating an investment's impact on the overall portfolio position, investors tend to focus on individual assets.
They either do not understand or choose to ignore the concept of selecting investments from a portfolio perspective. Result: more risk than is necessary due to a lack of diversification aka: mental accounting |
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Explain the influence of investor psychology on risk tolerance and investment choices
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Behavioral models indicate that the asset valuation process no longer incorporates only fundamental financial and economic variables. Behavioral finance assumes investors also include individual preferences based upon personal tastes. That is, individuals value investment characteristics that may or may not be validated by traditional finance concepts.
Additionally, individuals construct portfolios one asset at a time rather than using a portfolio/diversification (asset integration) approach. Wealth creation is determined not from an overall portfolio perspective but by making investment decisions that relate to specific goals. |
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Personality Typing Questionnaire
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Provides the investment manager and the client with some general classifications for the client's propensity to take risk.
Contains non-investment related questions Attempts to assign the client along two dimensions: 1. Risk Attitudes 2. Decision-making style |
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Name the four distinct investor personality types
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Cautious
Methodical Spontaneous Individualistic |
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Cautious Investor
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Focus on minimizing risk.
Have difficulty making investment decisions Exhibit low portfolio turnover |
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Methodical Investor
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Conservative nature
Focus on gathering as much data as possible Constantly on the outlook for new and better information |
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Individualistic Investor
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Have confidence in their investment decision making
Willing to do investment research Self-assured |
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Spontaneous Investor
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Exhibit high portfolio turnover
High trading costs They fear not reacting to changing market conditions, including latest investment fads |
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Benefits to Client of having a formal IPS
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Objectives and constraints are considered in formulating investment decisions that benefit the client in an optimal way
Dynamic process - allows for changes in circumstances Represents the long-term objectives of the investor Subsequent managers should be able to implement decisions in line with the investor's goals and objectives |
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Benefits to the Advisor
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If questions arise regarding specific investment decisions, the IPS can be consulted for clarification
Should indicate a direction for dispute resolution within the review process section |
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Explain the process involved in creating an IPS
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Objectives
Constraints Investment Strategy Asset Allocation Execution Modifications or Adjustments 1. Determine and evaluate the investor’s risk and return objectives. Planning return expectations should take place concurrently with risk tolerance discussions. 2. Determine portfolio constraints. 3. Define the appropriate investment strategy based upon an analysis of objectives and constraints and market expectations. 4. Determine the proper asset allocation to meet the investor’s objectives and constraints. 5. Execute portfolio decisions in a timely fashion and, after an agreed upon time period, evaluate performance. 6. Make modifications or adjustments to the portfolio as needed to ensure maintenance of originally stated objectives and constraints. |
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Required Return
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Based on required expenditures - mandatory objectives
Usually dictated by spending and growth objectives. |
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Desired Return
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Related to non-primary goals:
buying a vacation home Taking lavish vacations These items are not considered when calculating the total investable portfolio or required return |
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What should you consider when defining a client's Risk Objective?
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individual will have both a willingness and an ability to take risk. Ability to take risk can be more amenable to quantification due to the connection between goals and time horizon to reach those goals. However, willingness to take risk requires a more subjective analysis.
Willingness to take risk takes precedent unless doing so will cause client not to meet objectives. If this is the case, investor education is recommended. |
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What should you consider when defining a client's Return Objective?
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A distinction between required and desired return levels should be discussed with the client.
An explicit statement as to whether the returns are after-tax should also be made |
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Name the client constraints
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Time horizon
Taxes Liquidity Needs Legal and Regulatory Considerations Unique Circumstances |
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Time horizon
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the total time period over which the portfolio will be managed to meet the investor's objectives and constraints.
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Time horizon stage
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indicated any time the individual experiences or expects to experience a change in circumstances significant enough to require evaluating the IPS and reallocating the porfolio.
Can include retirement and major expenses such as college costs, or expected inheritance |
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Tax considerations
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Typically include income tax, capital gains tax, transfer tax, and wealth or personal property tax.
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Strategies used to redue the adverse impact of taxes
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Tax Deferral
Tax Avoidance Tax Reduction and Transferring Wealth to others without utilizing a sale |
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Liquidity
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Spending needs that will be met by the investment portfolio
Do not consider spending needs that will be met by salary or othe rincome sources. Assume the client will use current income from the portfolio and/or liquidate assets as necessary to meet spending needs. |
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Legal and regulatory factors
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Typically relate to tax relief and wealth transfer.
Usually call for legal advice |
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Unique Circumstances
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Special investment concerns
Special instructions Restrictions on the sale of assets Asset classes the client specifically forbids or limits based on past experience Assts held outside the investable portfolio (house, bequests Desired objectives not attainable due to time horizon or current wealth |
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Process of selecting a strategic asset allocation
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Select the allocation that best matches the objectives and constraints of the investor
A process of elimination can help: 1.Eliminate allocations that do not meet return objectives 2. Eliminate returns that violate statements relating to risk or safety first rules - may require calculations |
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Deterministic planning techniques
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Use single values for economic and financial variables - point estimates
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Main downside of deterministic planning techniques
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Investors do not have the capability of evaluating probabilities of that expected value occuring.
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Monte Carlo Techniques
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Take into account distributions and associated probabilities for input variables and generate a probabilistic forecast of retirement period values.
Investor can see a range of possibilities for the future |
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Name four benefits to Monte Carlo analysis
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1. Give the client and mgr a better indication of the risk/return tradeoff in investment decisions
2. Explicitly show the tradeoffs of short term risks and the risks of not meeting goals 3. Better able to incorporate tax nuances 4. Better model the complicatoins associated with future returns by more effectively incorporating the compounding effect of reinvestment |
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Common Progressive Tax Regime
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Most common regime
Tax Structure: Progressive Int Income: Favorable Div Income: Favorable Cap Gains: Favorable |
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Heavy Dividend Tax Regime
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Tax Structure: Progressive
Int Income: Favorable Div Income: Not Favorable Gap Gains: Favorable |
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Heavy Capital Gains Tax Regime
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Tax Structure: Progressive
Int Income: Favorable Div Income: Favorable Gap Gains: Not Favorable |
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Heavy Interest Tax
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Structure: Progressive
Int Income: Not Favorable Div Income: Favorable Cap Gains: Favorable |
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Light Capital Gain Tax
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Second Most Common
Structure: Progressive Int Income: Not Favorable Div Income: Not Favorable Cap Gains: Favorable |
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Flat and Light
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Structure: Flat
Int Income: Favorable Div Income: Favorable Cap Gains: Favorable |
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Flat and Heavy
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Structure: Flat
Int Income: Favorable Div Income: Not Favorable Cap Gains: Not Favorable |
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Accural equivalent after-tax return
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The annual return that produces the same terminal value as the taxable portfolio
Moves closer to the pre-tax return as the time horizon increases and as more of the porfolio return is deferred |
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Accural equivalent tax rate
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the tax rate that makes the pre-tax return equal to the accrual equivalent after tax return
The lower the accrual equivalent tax rate, the more tax efficient the investment is. |
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Investment income tax relationships to tax drag
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1. Tax Drag > Tax Rate
2. As investment horizon increases, tax drag increases 3. As investment return increases, tax drag increases |
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Deferred capital gains tax relationships to tax drag
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1. Tax Drag = Tax Rate
2. As investment horizon increases, tax drag is unchanged 3. As investment return increaes, tax drag is unchanged |
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Wealth-based tax relationships to tax drag
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1. Tax drag > Tax Rate
2. As the investment horizon increases, the tax drag increases 3. As the investment return increases, the tax drag decreases |
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Discuss the tax profile of tax deferred accounts
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these contributions:
reduce the taxpayers current taxes accrue tax free taxed when withdrawn in the future Have front-end tax benefits |
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Discuss the tax profile of tax exempt accounts
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Made with after-tax funds
Accrue tax-fee Withdrawn in the future tax free Have back-end tax benefits |
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Decision rules for determining which account will have the highest FV assuming equal investment returns and horizons.
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If current tax rate > future tax rate, FV TDA > FV TEA
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Explain how taxes affect investment risk
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The effect of taxes on investment risk depends on the type of investment account. If an investment is held in an account that is taxed annually, the government bears part of the investment risk. More specifically, if investment returns are taxed solely as income at the rate of TI and the pre-tax standard deviation of returns is σ, then the investor’s after-tax risk is σ(1 – TI).
On the other hand, if the investment is held in a tax-exempt account, then the investor bears all the investment risk. This is also true for TDAs because even though the government taxes the future accumulation, the variability of returns is not reduced by taxes levied at the time of withdrawal. |
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Asset location
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relates to whether assets are contained in tax advantaged accounts or taxable accounts
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Tax Alpha
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The value created by the effective tax management of investment securities
To generate alpha, an investor would locate heavily taxed assets in tax advantaged accounts and lightly taxed assets in taxable accounts. |
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Name the four types of investors based on trading behavior
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Traders
Active Investors Passive Investors Exempt investors |
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Traders
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Only Short term gains taxed annually
Frequent trading Forego many of the tax advantages of equity |
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Active Investors
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Trade less frequently than traders
generally, lower taxes on gains than traders |
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Passive Investors
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Buy and hold equity so that gains are deferred for the long-term
Taxed at preferential rates when gains are realized |
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Exempt Investors
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Hold all stock in tax-exempt accounts
Avoid taxes altogether |
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Tax Loss Harvesting
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uses investment losses to offset investment gains or income, resulting in a tax savings
Can sometimes be applied against past or future gains, but governments sometimes place limits Saves on current taxes but when old security is sold, the cost basis for future taxes is reduced resulting in higher tax in the future |
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Highest-in, first-out tax lot
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When allowed by a government, an investor liquidates the portion of a position with the higest basis first, minimizing current taxes
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What do HIFO and tax loss harvesting have in common?
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The minimization of current taxes, but total taxes are the same over time (assuming a constant tax rate)
Benefit:current taxes are minimized, allows for savings to be reinvested earlier, creating a tax alpha that compounds through time. |
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If future taxes may be higher than current taxes, what may an investor do?
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postpone tax loss harvesting and liquidate low cost basis stock now (LIFO accounting)
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Explain how taxes and asset location related to mean-variance optimization
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Ideally the efficient frontier of portfolios should be viewed on an after-tax basis. Furthermore, because the tax status of an investment depends on the type of account it is held in, the same asset could appear on the efficient frontier in both taxable and non-taxable forms.
For example, an investor holds both stocks and bonds in both taxable and tax-exempt accounts. In this case, there are four different assets that could appear on the efficient frontier. Of course, the optimization process would have to be constrained to account for limits on the amount of funds that can be placed in tax advantaged accounts and the type of assets that can be allocated to them. The mean-variance optimization should optimally allocate assets and determine the optimal asset location for each asset. Accrual equivalent after-tax returns would be substituted for before-tax returns and after-tax risk would be substituted for before-tax risk. |
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Will
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The most common tool used to transfer assets
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Probate
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Legal process that takes place at death during which a court:
a. determines the validity of the decendent's will b. inventories the decedent's property c. resolves any claims against the decedent, and d. distributes remaining property according to the will Due to the cost, time it takes and the public nature, individuals take steps to avoid it |
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List strategies used to avoid probate
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Joint ownership with rights of survivorship
Living trusts Retirement plans Life insurance |
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Lifetime gratuitious transfers
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aka - gifts
aka - intervivos transfers May be subject to gift taxes |
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Testamentary gratuitious transfers
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aka bequests
May be subject to estate taxes paid by the grantor or transfer taxes paid by the recipient |
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Difference between estate tax and transfer tax?
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Estate tax is paid by the grantor, transfer tax is paid by the recipient
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Foreced Heirship Rules
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Provide statutory ownership. Many apply claw-back provisions
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Community Property Rights Regime
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Each spouse is entitled to one-half of the estate earned during the marriage
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Separate Property Rights Regime
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Each spouse owns and controls his or her property, separate from the other
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Core Capital
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the amount necessary to meet all an individual's liabilities.
Equals the sum of the products of expected spending for each year by the probabilty of living that long |
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Problem with mortality tables
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An individual has a 50% probability of out-living mortality tables, so you should incorporate a safety reserve into core capital
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Probability of ruin
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the probability of running out of money
Usually positively correlated with level of spending |
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What method can you use to evaluate the probability of ruin?
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Monte Carlo simulation gives the expected portfolio value and distribution of possible values at retirement
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What is the estate planning benefit of making lifetime gifts when taxes are paid by the donor, rather than the recipient
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When the donor pays the gift taxes, the future value of the gift to the recipient is increased by an amount equal to the project of the estate and gift taxes (Tg and Te) and the value of the gift
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Name some estate planning strategies
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Spousal exemptions
Valuation discounts tax deductions on charitable gifts Generation skipping trusts |
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Revocable Trust
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the settlor can rescind the trust and is considered the legal owner of the assets for tax purposes
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Irrevocable Trust
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Trustee is considered the owner of the assets for tax purposes
Protects the assets from claims agains the settlor |
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Fixed Trust
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The pattern of distributions to the beneficiiaries is predetermined by the settlor and incorporated into the trust documents
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Discretionary Trust
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Trustee determines how the assets are distributed
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Spendthrift Trust
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Used to transfer assets to a beneficiary who is too young or is otherwise unable to manage the assets
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Explain how life insurance can be a tax efficient wasy to transfer wealth
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Proceeds generally pass tax free to beneficiaries
Policy might provide tax-fee accumulation of wealth or loans to policyholder on good terms Can avoid probate by making a trust the direct beneficiary |
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How are life insurance premiums handled in an estate tax context?
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Premiums: generally not considered part of the grantor's estate for tax purposes, but may be considered gifts to the beneficiary
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Source Jurisdiction
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aka territorial tax system
A country levies taxes on all income generated within its borders Wealth transfer taxes are levied on assets located within or transferred within a country. |
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Residence Jurisdiction
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Country taxes the global income of its residents, and citizens and residents pay wealth transfer taxes, regardless of the world-wide location of the assets
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Discuss the possible income and estate tax consequences of foreign situated assets and foreign sourced income
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In response to citizens who renounce their citizenship to avoid taxes, some residence jurisdictions impose an exit tax usually based on the gains on assets leaving, as if they were sold (deemed disposition). This could include a tax on income earned for a shadow period.
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Residence-Residence Conflict
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Two countries claim residence for the same individual
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Source-Source Conflict
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Two countries claim authority over the same income
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Residence Source Conflict
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An individual is subject to residence jurisdiction and receives income on assets in a foreign country with source jurisdiction
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Credit Method
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The residence country allows a tax credit for taxes paid to a source country
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Exemption Method
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The country of residence charges no income tax on income generated in a foreign country
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Deduction Method
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The individual is only allowed to deduct the amount of taxes paid to the source country
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Which method allows for partial resolution of the Residence-Source Conflict?
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Deduction
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Which methods allow for complete resolution of the Residence-Source Conflict?
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Exemption and Credit
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The deduction, exemption, and credit methods were designed to provide relief for what conflict?
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Residence-Source
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Is tax avoidance legal?
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Yes
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Is tax evation legal?
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No
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Tax avoidance
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attempting to structure estates to hold and transfer assets in the most tax-efficient ways.
Could include: Holding foreign assets Holding funds in a foreign country to more efficiently provide living and/or business expenses |
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Tax evasion
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hiding, misreprenting, or otherwise not recognizing income so as to illegally avoid taxation
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Describe the impact of increasing international transparency and information exchange on international estate planning.
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Qualified Intermediaries collect all the information required by the United States but provide the information on their U.S. customers only. A similar agreement exists in the European Union, by which EU member banks exchange customer information with each other.
Tax avoidance is legal, tax evasion is illegal |
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Basis
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aka cost basis
Refers to the reference point for calculating capital gains or losses for a given asset. Usually either the gross purchase price or the value of the asset when transferred to the holder |
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What is the problem with low-basis stock?
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The tax ramifications and other factors can serve to inhibit the investor from taking an action that would otherwise be desirable (ie, diversifying a portfolio).
Can lead to excessive portfolio risk |
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Why do entrepreneurs maintain concentrated portfolios?
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They have a psychological attachment to their firms.
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Why do entrepreneurs maintain concentrated portfolios?
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The the more control the executive exerts over the fortunes over the firm, the less concerned he is with diversification. He is also psychologically attached to the firm.
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Why are investors more willing to diversify?
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Does not exert significant control over the firm's operations so not as emotionally attached to the stock and is less willing to accept exposure to the specific risk of that stock
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Name the three types of risks faced by an investor
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Market risk
Specific Risk Residual Risk |
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Specific Risk
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Refers to the risk of the individual security - the risk that can be reduced or eliminated by holding the security in a diversified portfolio
aka - unsystematic risk |
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Residual Risk
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The risk associated with successfully implementing the desired strategy
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Name the two components of Residual Risk
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Counterparty Risk
Regulatory Risk |
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Counterparty Risk
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The probability that a counterparty will not correctly complete the transaction as expected
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Regulatory Risk
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The possibility that tax authorities will not accept the tax treatment applied to a transaction (ie, the value placed on private shares donated to charity)
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Entrepreneur's porfolio typically consists significant amounts of what types of risk?
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Specific Risk and Total Risk
The single holding of their firm's stock can represent total wealth |
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The executive's portfolio typically contains what types of risk?
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A significant amount of specific risk but less than the entrepreneur.
This is because the top executive's firm is probably more established than the entrepreneur's firm, so their stock holdings will contain less overall risk than the entrepreneur. |
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What generally leads to entrepreneur's maintaining concentrated positions in their portfolios?
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Psychological attachment to the firm.
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How does the element of control play into the concentratedness of entrepreneur and executives portfolios?
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Entrepreneurs and executives have confidence in their abilities to run the firm. The more control one exerts, the less concerned he is with diversification and the more psychologically attaached he becomes.
As control is transferred to others, the individual becomes less comfortable with a concentrated portfolio and will begin to diversify. |
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In the investor stage the individual has no _____ attachment to the firm
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Emotional/psychological
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Name four strategies used to reduce concentrated equity positions
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Sale
Exchange Fund Completion Portfolio Hedging |
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Pros of an outright sale of concentrated position
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Allows for maximum investment flexibility
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Cons of an outright sale of concentrated position
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Any unrealized capital gains are recognized immediately for tax purposes
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Exchange Fund
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Several individuals combine their large, low-basis holdings in a single portfolio. In exchange for a commitment to remain in the pool for a given period of time, the investor's low basis position becomes part of a well-diversified portfolio.
Can be public or private |
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Completion Portfolio
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Utilized by investors with other, liquid assets in addition to the low-basis position. The investor identifies a target porfolio (eg. index) that exhibits the desired degree of diversification and the manager purchases diversifying shares using existing funds, by borrowing funds, or by using portfolio cash flows
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Hedging (in the context of diversifying a concentrated holding)
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Action of first choice in achieving desired diversification. Investors must be aware of constructive sale provisions
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Constructive sale rule
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Transactions that effectively take an offsetting position in the currently owned position.
Designed to prevent investors from locking in investment gains without paying capital gains and to limit their ability to transfer gains from one tax period to another. |
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Name two other methods utilizing alternative investments that one could use to diversify a concentrated position
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Equity collar
Pre-paid forward |
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Traditional finance tends to think of investment results in terms of:
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percentage returns
statistical risk reward-to-risk ratios |
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Investors tend to think of investment results in terms of:
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Personal lifestyle objectives
Gifts to others Gifts to charity |
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What is the benefit of defining portfolio performance in terms of lifestyle objectives?
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Can help improve an investors understanding of how investment policy relates to goal achievement.
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Explain the limitations of traditional risk measurement and risk profiling in setting investment policy for individual investors
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Traditional finance would develop the investor’s policy objectives in terms of risk (standard deviation) and expected return in percent. Yet, for most investors, it is difficult to translate a percentage expected return and standard deviation into the probability that enough funds will be available to accomplish investment objectives. Moreover, without a connection between investment policy and the probable attainment of the desired objective, it can be easier for the investor to deviate from any policy statement developed.
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Absolute Performance Strategy
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The investor specifies a desired minimum spending level during retirement.
The manager translates the spending level into a minimum return requirement and provides various possible asset allocations, each with an expected return equal to or greater than the required return. Returns distributions for the alternatives are presented to the investor in terms of max return potential and maximum loss. Each possible max and min return can be translated into a sustainable lifestyle |
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Cash Flow Matching
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When an individual's goals can be stated in exact cash amounts, you can use this strategy by utilizing a laddered bond strategy.
Bonds are purchased with maturities matching the target dates such that the maturity of one bond combined with the cash flows from the longer term bonds meet each cash flow. |
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Fixed Horizon Strategy
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Ensures that a given minimum investment objective is attained.
Analogous to an insured portfolio strategy. Some amount of potential return is sacrificed in exchange for greater certainty |
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Name the three ways in which a Fixed Horizon Strategy differs from a Traditional Asset Allocation Strategy
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1. There is zero probability that funds will be insufficient to meet the investment goal
2. The cost of eliminating shortfall risk is the reduction of upside potential 3. The allocation may not be constant through time |
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Shortfall risk
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The risk of not having sufficient funds
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How does one decide between a Fixed Horizon Strategy or Traditional Asset Allocation?
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1. The importance of achiving the minimum defined objective
2. The potential for making up any shortfall at the end of the horizon period 3. The importance of achieving the maximum defined objective |
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Human Capital
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The present value of earned income - income generated by the individual's labor
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Financial Capital
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Passive income generated by investments - equals the total value of financial assets owned
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Name some of the forms of human capital?
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Salary
Bonus Social Security Employee Related Pensions |
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Does an individual's human capital always drop to zero at retirement?
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Not necessarily. Pensions. Social Security
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Earnings Risk
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The potential for a disruption in the expected income flow
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What are some possible remedies for earnings risk?
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1. Increasing the savings rate
2. Minimizing the correlation of human and financial capital 3. Offsetting the risk of the human capital with financial capital |
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Mortality Risk
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The sudden, unexpected loss of human capital caused by premature death.
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What is the most common hedge used against mortality risk?
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Life Insurance. Has a perfect negative correlation with human capital
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Longevity Risk
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The inability of your financial assets to meet your living expenses because
a. You live longer than expected or b. financial capital has dropped unexpectedly and severely |
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What is the most common remedy against longevity risk?
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Lifetime payout annuity
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Total Wealth
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Financial Capital + Human Capital
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Characteristics of equity like human capital
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High expected return
High variability OR High correlation with equity markets |
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Characteristics of fixed income like human capital
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Low volatility
Low correlation with equity markets |
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For an individual with equity-like human capital, an increased allocation to ________ is warranted
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Fixed income securities
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For an individual with bond-like human capital, an increased allocation to ________ is warranted.
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Equities
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How is asset allocation affected by human capital?
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We should consider the human capital’s inherent risk, its correlation with other assets, and its size relative to the rest of the portfolio.
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What is the relationship between risk aversion and life insurance?
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Positively correlated
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How is a bequest desire related to the demand for life insurance?
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Positively related
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How is human capital related to the demand for life insurance?
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Equity like characteristics of HC dictate a higher discount rate, a lower present value and a lower demand for life insurance
Relates to value of what you are replacing with life insurance Equity like HC - lower demand for life insurance Bond like HC - higher demand for life insurance |
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What are the three primary risk factors that could jeopardize the desired lifestyle and/or bequest?
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1. Financial Market Risk
2. Longevity Risk 3. Savings Risk |
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Financial market risk
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the effects of volatility in the financial markets that could result in significant drops in portfolio values.
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What is the primary means of mitigating financial market risk?
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Diversification
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Longevity Risk
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The risk of out-living one's financial assets
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Actuarial life expectancy
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Based on population averages. Half will reach the age, but many will live longer
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What is the primary tool for mitigating longevity risk?
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Lifetime payout annuities.
Pensions (including SS) also represent possible solutions |
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Savings risk
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aka spending uncertainty
Relates to spending more than you should so that you save less than you should during the accumulation phase |
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What is one possible took for mitigating savings risk?
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SMarT or save more tomorrow programs
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SMarT program
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program in which an individual pledges to save a portion of future raises
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Fixed annuities
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pay a set nominal amount each period for the life of the investor
The real values of the cash flows fall over time due to inflation |
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Variable annuities
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annuity that is indexed to some underlying investment
Provides a lifetime cash flow |
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What is a downside to a fixed annuity?
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Since the cash flows are stated in constant nominal terms, the real values of the cash flows fall over time due to inflation
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What is a downside to a variable annuity?
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In some periods the funds perform well and provide high returns. In other periods, the payments might fail to meet the investor's needs.
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One should always offset the risk of the human capital with the risk of what?
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Financial capital.
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If human capital is equity-like, then allocate more of the financial portfolio to....
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Fixed income with less demand to life insurance
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If the human capital is bond-like, then allocate more of the financial portfolio to...
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Equities with increased demand for life insurance
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Financial capital is based on what two factors?
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An expected savings rate and
An expected return on capital |
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Describe the relationship between an investors human capital and financial capital and stage of life cycle?
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When the investor first enters the accumulation phase, human capital is typically at its highest and financial capital at its lowest. At that time, the alloation to risky assets depends on the nature of the investor's human capital
As the invesor ages, financial capital increases and human capital decreases. If the investor is successful, financial wealth grows to a point where life insurance is no longer needed as a hedge against mortality risk. |
