M ANANGING I NDIVIDUAL I NVESTOR P ORTFOLIO Portfolio Management Prof. Ali Nejadmalayeri

Investor Characteristics Situational Profiling –Source of Wealth –Measure of Wealth –Stage of Life Psychological Profiling –Traditional vs. Behavioral Finance –Personality Typing Cautious Methodical Spontaneous Individualist

Situational Profiling Source of Wealth –Self-made vs. passive investors Measure of Wealth –Wealthy relative to spending Stage of Life –Foundation Phase –Accumulation Phase –Maintenance Phase –Distribution Phase

Stages of Life Foundation –Establishing the base from which wealth generated Acquiring marketable skills, starting a business, etc. Accumulation –Earning accelerates from marketable skills Rising salaries/income and expenses, house, kids, etc. Maintenance –Retired from daily jobs and businesses Distribution –Wealth is transferred to heirs or charity

Psychological Profiling Traditional Finance –Risk aversion –with equal return, less dispersion is preferred –Rational Expectation: –Forecasts are coherent, accurate, and unbiased –Asset Integration: –Decisions are made on a portfolio basis not asset basis Behavioral Finance –Loss aversion: –Biased Expectation: –Asset Segregation:

Personality Typing Decisions based primarily on Thinking Decisions based primarily on Feeling More Risk Averse MethodicalCautious Less Risk Averse IndividualistSpontaneous

Personality Typing Decisions based primarily on Thinking Decisions based primarily on Feeling More Risk Averse MethodicalCautious Less Risk Averse IndividualistSpontaneous Peter HansHilda Christa

Inger’s family IPS Return ObjectiveReturn Objective –Given their current needs, they needs €500,000 annually to meet their expenses –Return objectives are based on total approach, no distinction between growth or income streams –Step One: Budget inflows –Step Two: Budget outflows –Step Three: Determine shortfall and then required return

Return Objective Cash flow statement [Exhibit 2-4] –Year two distribution is €493,949 Balance Sheet [Exhibit 2-5] –Net worth is €51,040,437 from which €42,340,437 is investable assets Required return is €493,949/ €42,340,437 or 1.17% per annum Considering a 3% annual inflation, the required return is 4.17%

Inger’s Family IPS Risk ObjectiveRisk Objective –Ability to take risk What are short- and long-term financial needs & goals? –Supporting life-style, kids education, second home, financial security in long-term How important are these goals? How serious are the consequences if they are not met? How large of a shortfall can the investor weather? –Willingness to take risk More objective assessment, psychological profiling can help to determine the willingness

Risk Objective Ability: –Short-term and Intermediate Goals Support of life-style, construction of a second home, investment in magazine Exteriors, support grandson’s education, expansion’s of wife’s design studio –Long-term Goals Preservation of financial security and purchase power –Overall “above average” ability to take risk Willingness: –As an entrepreneur, Peter is able to take risk, but his desire for control limits his willingness. His assertion of only a 5% loss being tolerable can be revised to a 10% loss. “below average” willingness.

Inger’s Family IPS ConstraintsConstraints –Liquidity Ability to meet unexpected cash flow needs –Time Horizon Single- or multi-stage –Taxes Capital gains and income plus special cases like estate –Legal & Regulatory Environment Particular regulatory concerns, e.g. insider ownership –Unique Circumstances Family emergency, wills, donations, etc.

Liquidity Constraints Factors: transaction costs and price volatility Requirements: –Ongoing Expenses Annual expense €500,000 + grandson’s support €15,000 Second home (next 1 – 3 years): €7 millions Probable investment in magazine: €5 millions –Emergency Reserves €1 millions –Negative Liquidity Events Illiquid holdings: –Large illiquid in one company and residence

Time Horizon Constraints Anecdotal “short-term” and “long-term” –Intermediate horizons: 3 – 15 years –Long horizons: 15 – 20 years Peter and Hilda want a “family” plan –Many generations, multi-stage Their own retirement Their children financial stability Their grandchildren’s education

Tax Constraints Income, Gain, Wealth Transfer, Property Tax Tax deferral: –401K, IRA, along with tax loss harvesting Tax avoidance: –Tax exempt bonds, gifting Tax reduction –“tilt” toward income or gains based on situation Wealth transfer: –Transfer at Death: inheritance tax –Early Transfer: gifts; subject to assumed tax status

Legal & Regulatory Constraints Personal Trusts: [common-law: US & UK] –Revocable: flexible used along with a will Grantor may be subject to taxation due to control –Irrevocable: inflexible, transfer of property Trust, not grantor, is liable for taxes Family Foundations: [civil-law: Europe] –Gifting to grandchildren: irrevocable trust –Gifting to children: trust or foundation –Gifting with retained interest: various options Retain control-disburse income hybrid structure Charitable remainder trust

Unique Circumstance Constraints Care of ill or underage relatives –Elderly parents with health issues –Orphan children Self-imposed investment restriction Ownership of private, illiquid assets Insider or material ownership of companies Real estate/vacation home dreams Estate planning and gifting wishes Multi-generational challenges

Basics of Asset Allocation Required return is met Risk requirements are met –Desired standard deviation –Desired probability of shortfall Or least Value-at-Risk (VaR) Overall efficiency: highest Sharpe ratio –Given constraints, highest Sharpe ratio corner portfolio is the most efficient one Well-diversified portfolio are preferred –Particularly for older investors with greatest desire to preserve capital, a well-balanced portfolio needed