CFA Level 3: Individual and Institutional Investors (Part 1)

Managing Individual Investor Portfolios

• Investment Objectives and Constraints ("RRTTLLU")

Objectives Constraints

• Return
• Time horizon
• Risk
• Taxes
• Liquidity
• Legal and regulatory needs
• Unique preferences

Typical IPS Elements:

• Client description
• Purpose of the IPS
• Identification of duties and responsibilities
• Formal statement of objectives and constraints
• Calendar schedule for portfolio performance and IPS review
• Performance measures and benchmarks
• Considerations for developing the strategic asset allocation (SAA)
• Investment strategies and styles (e.g., active, passive, semi-active)
• Guidelines for portfolio adjustments and rebalancing Reasons to Revise and IPS:
• Change in personal circumstances (e.g., change in marital status, health, income, etc.)
• Change in external conditions (e.g., change in tax laws, capital market expectations, asset availability, etc.)
• Large loss in the portfolio Individual IPS (Example statements)

Objectives

• Return Requirement
  • "$XX annually for [living expenses, parent's care]"
  • "Formulate the return requirement" = list the spending needs
  • "Maintain real value of portfolio"
• Risk Tolerance
  • Always start with "average risk tolerance" as basis and look for key characteristics that diverge from "average."
    1. Ability:
    • "Long time horizon" (young, good health)
    • "Large asset base relative to expenses"
    • "Could reduce living expenses and gifts" (flexibility)
    • "Could alter lifestyle" (flexibility)
    • "Large portfolio relative to liquidity needs and the time horizon"
    • "Investment portfolio is only source of income"
    • "Wants to maintain real value of portfolio" 2. Willingness:
    • Actions speak louder than words.
    • "Makes own investment decisions"
    • "Holds small number of individual stocks"
    • "No annual loss > 6%"
    • "Avoid high-risk investments" 3. Overall:
    • If willingness < abilty, honor willingness. Recommend education or counseling to reconcile the difference.
    • If willingness > ability, honor ability. Recommend education or counseling to reconcile the difference

Constraints

• Time Horizon

  • Long-term with 2 stages: (1) until dependent's care ends; (2) remaining years until own death
  • Pre-retirement/employment and retirement
  • If the expenditure is low relative to the portfolio, it may not be necessary to delineate a separate time horizon (i.e., reallocated portfolio).
  • "Possible 3rd stage is needed"

• Taxes

  • Taxed as an individual
  • Consider usage of tax-sheltered account
  • Taxable: all taxes should be considered in portfolio decisions
  • Charitable contributions should be made tax efficiently
  • Always look for anything unusual, such as trusts, foundations, or charitable gifts.

• Liquidity Needs

  • Include only spending requirements that must be met by the portfolio; any expenses that exceed salary
  • $XX for next year's living expenses / dependent's care / charitable gifts
  • Emergency reserve (5-6 months' salary)

• Legal/Regulatory Concerns

  • There are no special legal or regulatory issues
  • Seek legal counsel to establish a trust (or succession planning) for surviving dependents'/heirs' care
  • Create tax-shelted accounts for dedicated purpose

• Unique Circumstances

  • Care for dependents
  • Large holding of an illiquid stock
  • Large holding of a low-basis stock
  • Socially conscious (responsible) investing (SRI)
  • Future charitable contributions
  • Desire to avoid particular stocks, sectors, etc.
  • Single with no dependents