1. Building The Future of Financial Advising F I N A N C E W A R E “The Concentration Crisis” RISK WITHOUT REWARD The recent collapse of Enron has highlighted the risk of concentrated investments... While this has raised the awareness of concentration risk, one doesn’t need scandal and bankruptcy to suffer the same fate as Enron’s investors. Many investors unknowingly are accepting… ©Copyright Financeware, Inc. 2002 All rights reserved

2. PAGE 2 The Concentration Crisis… Like some of Enron's investors and employees… Many investors have “concentrated” stock positions from: 1. stock of their employer 2. stock they inherited 3. a position that has grown and dominates their portfolio These investors often ignore one of the basic premises of asset allocation…that is, There is NO REWARD for RISK that can be diversified away. This presentation exposes this needless risk and… 1. Explains what causes this risk 2. How to measure exposure to it 3. And, how to correct it to confidently achieve financial goals Introduction to the “Concentration Crisis”

3. ©Copyright Financeware, Inc. 2002 All rights reserved PAGE 3 What is “Concentration Risk”? “Concentration Risk” is unnecessary risk assumed by investors with investments that are materially over-weighted in a one or more securities. It is caused by: » Ignorance… improperly analyzing asset allocation » Uninformed or psychologically driven tax avoidance » Corporate “benefit” plans encouraging company stock ownership (ESOP, deferred compensation plans, etc.) The Enron scandal may have caused the company’s failure… But, the most serious pain of Enron’s investors were due to these causes… We will review these causes and demonstrate how to AVOID the same fate as Enron’s investors Introduction to the “Concentration Crisis”

4. ©Copyright Financeware, Inc. 2002 All rights reserved PAGE 4 Improper Asset Allocation Analysis Most asset allocation systems and services are based on Modern Portfolio Theory (MPT) MPT focuses on the “optimal” blend of asset CLASSES that fall on the “efficient frontier” Based on the following premises: 1. Portfolio risk is measured by volatility of returns relative to the portfolio’s average return (standard deviation= volatility relative to mean return) 2. Investors will seek the highest return for the maximum risk they can tolerate Asset Allocation – Modern Portfolio Theory (MPT) More Risk Less Risk Less Return More Return Theoretical Risk (standard deviation) Theoretical Return (average return) “Efficient Frontier” Inefficient Portfolio Causes of Concentration Risk

5. ©Copyright Financeware, Inc. 2002 All rights reserved PAGE 5 Same Risk, Higher Return Same Return, Lower Risk Improper Asset Allocation Analysis The “magic” of MPT was the theoretical ability to improve portfolio risk & return by: » Blending asset CLASSES that are not perfectly correlated to one another » To improve a portfolio’s asset allocation so that it would fall on the “efficient frontier” Asset Allocation – Modern Portfolio Theory (MPT) More Risk Less Risk Less Return More Return Theoretical Risk (standard deviation) Theoretical Return (average return) “Efficient Frontier” Inefficient Portfolio Causes of Concentration Risk

6. ©Copyright Financeware, Inc. 2002 All rights reserved PAGE 6 Improper Asset Allocation Analysis The “magic” of MPT was the theoretical ability to improve portfolio risk & return by: » Blending asset CLASSES that are not perfectly correlated to one another » To improve a portfolio’s asset allocation so that it would fall on the “efficient frontier” 1 This makes sense because 90% of portfolio variance is explained by asset allocation… BUT… What makes an asset class? Is an individual stock an asset class? Same Risk, Higher Return Same Return, Lower Risk Asset Allocation – Modern Portfolio Theory (MPT) More Risk Less Risk Less Return More Return Theoretical Risk (standard deviation) Theoretical Return (average return) “Efficient Frontier” Inefficient Portfolio Causes of Concentration Risk 1 Financial Analysts Journal – Brinson Beebower & Hood

7. ©Copyright Financeware, Inc. 2002 All rights reserved PAGE 7 Improper Asset Allocation Analysis Before MPT, another theory called the Capital Asset Pricing Model (CAPM) helped explain why asset classes need to be diversified… AND It also “proved” why NO ONE should put most of their money in a single stock Same Risk, Higher Return Same Return, Lower Risk Asset Allocation – Modern Portfolio Theory (MPT) More Risk Less Risk Less Return More Return Theoretical Risk (standard deviation) Theoretical Return (average return) “Efficient Frontier” Inefficient Portfolio Causes of Concentration Risk

8. ©Copyright Financeware, Inc. 2002 All rights reserved PAGE 8 Improper Asset Allocation Analysis Before MPT, another theory called the Capital Asset Pricing Model (CAPM) helped explain why asset classes need to be diversified… AND It also “proved” why NO ONE should put most of their money in a single stock CAPM looks like a fairly complicated formula: But it is really quite simple and some aspects of the theory make a lot of sense Same Risk, Higher Return Same Return, Lower Risk Asset Allocation – Modern Portfolio Theory (MPT) More Risk Less Risk Less Return More Return Theoretical Risk (standard deviation) Theoretical Return (average return) “Efficient Frontier” Inefficient Portfolio Causes of Concentration Risk CAPM Formula: R=R F + (ß X (R M – R F ))

9. ©Copyright Financeware, Inc. 2002 All rights reserved PAGE 9 Improper Asset Allocation Analysis Before MPT, another theory called the Capital Asset Pricing Model (CAPM) helped explain why asset classes need to be diversified… AND It also “proved” why NO ONE should put most of their money in a single stock CAPM looks like a fairly complicated formula: But it is really quite simple and some aspects of the theory make a lot of sense Same Risk, Higher Return Same Return, Lower Risk Asset Allocation – Modern Portfolio Theory (MPT) More Risk Less Risk Less Return More Return Theoretical Risk (standard deviation) Theoretical Return (average return) “Efficient Frontier” Inefficient Portfolio Causes of Concentration Risk CAPM Formula: R=R F + (ß X (R M – R F )) While MPT dealt with portfolio risk & return and the impact of different ASSET CLASSES CAPM dealt with the risk and return of investing in stocks in general

10. ©Copyright Financeware, Inc. 2002 All rights reserved PAGE 10 Improper Asset Allocation Analysis Before MPT, another theory called the Capital Asset Pricing Model (CAPM) helped explain why asset classes need to be diversified… AND It also “proved” why NO ONE should put most of their money in a single stock CAPM looks like a fairly complicated formula: But it is really quite simple and some aspects of the theory make a lot of sense Same Risk, Higher Return Same Return, Lower Risk Asset Allocation – Modern Portfolio Theory (MPT) More Risk Less Risk Less Return More Return Theoretical Risk (standard deviation) Theoretical Return (average return) “Efficient Frontier” Inefficient Portfolio Causes of Concentration Risk CAPM Formula: R=R F + (ß X (R M – R F )) While MPT dealt with portfolio risk & return and the impact of different ASSET CLASSES CAPM dealt with the risk and return of investing in stocks in general under the following premises… Premises of CAPM theory: » There are two kinds of risk: » Diversifiable Risk – “Event Risk” (Non-Systematic Risk) » Non- Diversifiable Risk – “Market Risk” (Systematic Risk)

11. ©Copyright Financeware, Inc. 2002 All rights reserved PAGE 11 Improper Asset Allocation Analysis Causes of Concentration Risk What CAPM attempted to “prove”: » You are rewarded for taking Market Risk » BUT NOT FOR RISK YOU CAN DIVERSIFY AWAY (Diversifiable Risk) » Risk is measured by Beta, and investors will seek to achieve the highest return for the maximum risk (Beta) they can tolerate » Beta forecasts the expected return according to the CAPM formula » Diversified portfolios are efficient Premises of CAPM theory: » There are two kinds of risk: » Diversifiable Risk – “Event Risk” (Non-Systematic Risk) » Non- Diversifiable Risk – “Market Risk” (Systematic Risk) CAPM dealt with the risk and return of investing in stocks in general under the following premises… While many of these points are still being debated years later…

12. ©Copyright Financeware, Inc. 2002 All rights reserved PAGE 12 Over The Long Term: » Risk is rewarded with return » Provided that the risk being taken is ONLY “Market Risk” (Systematic Risk or Non-Diversifiable Risk) Risk that could be diversified away (or made more efficient) IS NOT REWARED There are two rules of the Capital Asset Pricing Model (CAPM) and Modern Portfolio Theory (MPT) that are generally accepted… Causes of Concentration Risk

13. ©Copyright Financeware, Inc. 2002 All rights reserved PAGE 13 Over The Long Term: » Risk is rewarded with return » Provided that the risk being taken is ONLY “Market Risk” (Systematic Risk or Non-Diversifiable Risk) Risk that could be diversified away (or made more efficient) IS NOT REWARED Therefore, in asset allocation you MUST consider the risk of concentrated stock positions BECAUSE: One stock is obviously more volatile than 500 stocks… (the average stock is 3.2 TIMES as volatile) THEREFORE: Assuming that a single stock will perform like its asset class… is a COMPLETELY ERRONEOUS ASSUMPTION Causes of Concentration Risk There are two rules of the Capital Asset Pricing Model (CAPM) and Modern Portfolio Theory (MPT) that are generally accepted…

14. ©Copyright Financeware, Inc. 2002 All rights reserved PAGE 14 Over The Long Term: » Risk is rewarded with return » Provided that the risk being taken is ONLY “Market Risk” (Systematic Risk or Non-Diversifiable Risk) Risk that could be diversified away (or made more efficient) IS NOT REWARED Therefore, in asset allocation you MUST consider the risk of concentrated stock positions BECAUSE: One stock is obviously more volatile than 500 stocks… (the average stock is 3.2 TIMES as volatile) THEREFORE: Assuming that a single stock will perform like its asset class… is a COMPLETELY ERRONEOUS ASSUMPTION Causes of Concentration Risk Yet many asset allocation systems and services make this mistake… Improper Asset Allocation Analysis

15. ©Copyright Financeware, Inc. 2002 All rights reserved PAGE 15 Over The Long Term: » Risk is rewarded with return » Provided that the risk being taken is ONLY “Market Risk” (Systematic Risk or Non-Diversifiable Risk) Risk that could be diversified away (or made more efficient) IS NOT REWARED Therefore, in asset allocation you MUST consider the risk of concentrated stock positions BECAUSE: One stock is obviously more volatile than 500 stocks… (the average stock is 3.2 TIMES as volatile) THEREFORE: Assuming that a single stock will perform like its asset class… is a COMPLETELY ERRONEOUS ASSUMPTION Causes of Concentration Risk Improper Asset Allocation Analysis Yet many asset allocation systems and services make this mistake… Based on studies that showed: 1 90% of portfolio variance is explained by asset allocation… 1 Financial Analysts Journal – Brinson Beebower & Hood

16. ©Copyright Financeware, Inc. 2002 All rights reserved PAGE 16 Causes of Concentration Risk Improper Asset Allocation Analysis Yet many asset allocation systems and services make this mistake… Based on studies that showed: 1 90% of portfolio variance is explained by asset allocation… And making the erroneous conclusion that the asset class is more important than portfolio composition… Or in other words, they completely ignore diversifiable risk 1 Financial Analysts Journal – Brinson Beebower & Hood

17. ©Copyright Financeware, Inc. 2002 All rights reserved PAGE 17 Causes of Concentration Risk Improper Asset Allocation Analysis Yet many asset allocation systems and services make this mistake… Based on studies that showed: 1 90% of portfolio variance is explained by asset allocation… And making the erroneous conclusion that the asset class is more important than portfolio composition… Or in other words, they completely ignore diversifiable risk Usually, such systems emphasize classification of securities to non-diversified asset classes like: 1 Financial Analysts Journal – Brinson Beebower & Hood A Diversified Portfolio of Stocks, Bonds & Cash? Value Stocks Growth Stocks Foreign Stocks Small Cap Stocks Mid Cap Stocks

18. ©Copyright Financeware, Inc. 2002 All rights reserved PAGE 18 Causes of Concentration Risk Improper Asset Allocation Analysis Yet many asset allocation systems and services make this mistake… Based on studies that showed: 1 90% of portfolio variance is explained by asset allocation… And making the erroneous conclusion that the asset class is more important than portfolio composition… Or in other words, they completely ignore diversifiable risk Usually, such systems emphasize classification of securities to non-diversified asset classes like: 1 Financial Analysts Journal – Brinson Beebower & Hood A Diversified Portfolio of Stocks, Bonds & Cash Value Stocks Growth Stocks Foreign Stocks Small Cap Stocks Mid Cap Stocks Even though these studies actually showed that 90% of portfolio variance was explained by asset allocation to…

19. ©Copyright Financeware, Inc. 2002 All rights reserved PAGE 19 Causes of Concentration Risk Improper Asset Allocation Analysis Yet many asset allocation systems and services make this mistake… Based on studies that showed: 1 90% of portfolio variance is explained by asset allocation… And making the erroneous conclusion that the asset class is more important than portfolio composition… Or in other words, they completely ignore diversifiable risk Usually, such systems emphasize classification of securities to non-diversified asset classes like: 1 Financial Analysts Journal – Brinson Beebower & Hood A Diversified Portfolio of Stocks, Bonds & Cash Value Stocks Growth Stocks Foreign Stocks Small Cap Stocks Mid Cap Stocks Even though these studies actually showed that 90% of portfolio variance was explained by asset allocation to… And demonstrated that security selection, market timing and other asset classes collectively explained less than 10% of portfolio return variance

20. ©Copyright Financeware, Inc. 2002 All rights reserved PAGE 20 Causes of Concentration Risk Improper Asset Allocation Analysis Many Enron investors, and in fact, ANY investor that is materially over- weighted in a few positions is making this asset allocation mistake The impact to achieving financial goals can be devastating… And in the future will hurt many investors that continue to ignore these facts 1 90% of portfolio variance is explained by asset allocation… And Or in other words, they completely ignore diversifiable risk Usually, such systems emphasize classification of securities to non-diversified asset classes like: 1 Financial Analysts Journal – Brinson Beebower & Hood A Diversified Portfolio of Stocks, Bonds & Cash Value Stocks Growth Stocks Foreign Stocks Small Cap Stocks Mid Cap Stocks Even though these studies actually showed that 90% of portfolio variance was explained by asset allocation to… And demonstrated that security selection, market timing and other asset classes collectively explained less than 10% of portfolio return variance

21. ©Copyright Financeware, Inc. 2002 All rights reserved PAGE 21 Improper Asset Allocation Analysis Causes of Concentration Risk For example… We can gain some perspective of ignoring this risk by looking at a case study: Harry is 55 years old Has $1 million in company stock Will save $10,000 a year until retirement at age 65 Needs $75,000 a year in retirement income And wants to leave a $1 million estate (he doesn’t want to spend any principal)

22. ©Copyright Financeware, Inc. 2002 All rights reserved PAGE 22 Improper Asset Allocation Analysis Measuring Exposure to Concentration Risk For example… We can gain some perspective of ignoring this risk by looking at a case study: Harry is 55 years old Has $1 million in company stock Will save $10,000 a year until retirement at age 65 Needs $75,000 a year in retirement income And wants to leave a $1 million estate (he doesn’t want to spend any principal) If we assume his company stock will perform like its asset class, it appears Harry can be fairly confident in achieving his goals… We evaluated 1000 simulations generating random returns and life spans. Your portfolio met your target value of $1,000,000 at your death in 784 of these simulations. This is a 78% rate of success. In 152 simulations (15%), your plan not only failed to achieve the desired value of your portfolio, but also ran out of money during your life.

23. ©Copyright Financeware, Inc. 2002 All rights reserved PAGE 23 Improper Asset Allocation Analysis For example… We can gain some perspective of ignoring this risk by looking at a case study: Harry is 55 years old Has $1 million in company stock Will save $10,000 a year until retirement at age 65 Needs $75,000 a year in retirement income And wants to leave a $1 million estate (he doesn’t want to spend any principal) If we assume his company stock will perform like its asset class, it appears Harry can be fairly confident in achieving his goals… But, in reality his portfolio will be much more volatile than the asset class we assumed (on average 3.2 times as volatile) So instead of this confidence level: His odds really look more like this: Measuring Exposure to Concentration Risk

24. ©Copyright Financeware, Inc. 2002 All rights reserved PAGE 24 Measuring Exposure to Concentration Risk The best way to measure this risk is to define all of your financial goals… And measure the odds of success using probability analysis Harry is 55 years old Has $1 million in company stock Will save $10,000 a year until retirement at age 65 Needs $75,000 a year in retirement income And wants to leave a $1 million estate (he doesn’t want to spend any principal) If we assume his company stock will perform like its asset class, it appears Harry can be fairly confident in achieving his goals… But, in reality his portfolio will be much more volatile than the asset class we assumed (on average 3.2 times as volatile) So instead of this confidence level: His odds really look more like this: Measuring Exposure to Concentration Risk

25. ©Copyright Financeware, Inc. 2002 All rights reserved PAGE 25 Measuring Exposure to Concentration Risk The best way to measure this risk is to define all of your financial goals… And measure the odds of success using probability analysis Or, if desired (although it is somewhat harder to personalize and understand the impact) One can use traditional CAPM & MPT risk and return analysis (CSCO was used in this example) Measuring Exposure to Concentration Risk

26. ©Copyright Financeware, Inc. 2002 All rights reserved PAGE 26 Measuring Exposure to Concentration Risk The best way to measure this risk is to define all of your financial goals… And measure the odds of success using probability analysis Or, if desired (although it is somewhat harder to personalize and understand the impact) One can use traditional CAPM & MPT risk and return analysis (CSCO was used in this example) Measuring Exposure to Concentration Risk Notice the impact to risk and return of a single stock (CSCO for example) relative to more diversified portfolios of large and small cap stocks

27. ©Copyright Financeware, Inc. 2002 All rights reserved PAGE 27 Uninformed or Psychologically Driven Tax Avoidance One of the other primary causes of investors accepting this risk is tax avoidance However, we can measure this impact as well Harry is 55 years old Has $1 million in company stock Will save $10,000 a year until retirement at age 65 Needs $75,000 a year in retirement income And wants to leave a $1 million estate (he doesn’t want to spend any principal) If we assume his company stock will perform like its asset class, it appears Harry can be fairly confident in achieving his goals… But, in reality his portfolio will be much more volatile than the asset class we assumed (on average 3.2 times as volatile) So instead of this confidence level: His odds really look more like this: Causes of Concentration Risk

28. ©Copyright Financeware, Inc. 2002 All rights reserved PAGE 28 Uninformed or Psychologically Driven Tax Avoidance One of the other primary causes of investors accepting this risk is tax avoidance However, we can measure this impact as well Harry is 55 years old Has $1 million in company stock Will save $10,000 a year until retirement at age 65 Needs $75,000 a year in retirement income And wants to leave a $1 million estate (he doesn’t want to spend any principal) If we assume his company stock will perform like its asset class, it appears Harry can be fairly confident in achieving his goals… In Harry’s case, paying taxes now and diversifying has this impact… (assumes zero cost basis) Odds of success in meeting lifetime goals if: Harry avoids taxes until death:Pays $250,000 in taxes and diversifies: Causes of Concentration Risk

29. ©Copyright Financeware, Inc. 2002 All rights reserved PAGE 29 Uninformed or Psychologically Driven Tax Avoidance Why would investors take these risks, just to avoid taxes? Causes of Concentration Risk “But I Don’t Want To Pay The Taxes”… “I’ll Lose 20% To The Government”

30. ©Copyright Financeware, Inc. 2002 All rights reserved PAGE 30 Uninformed or Psychologically Driven Tax Avoidance Why would investors take these risks, just to avoid taxes? Causes of Concentration Risk “But I Don’t Want To Pay The Taxes”… “I’ll Lose 20% To The Government” BUT… YOUR STOCK IS ONLY WORTH WHAT YOU CAN CONVERT IT INTO CASH: » Taxes You Owe Do Not Show Up On Your Account Statement » What a Stock is Worth TO YOU, depends on How Much You Would Have to Pay In Taxes To Convert It Into CASH Taxes Are Like A Debt You Owe When Calculating The Value of your Net-worth, Do You Ignore The Mortgage On Your Home? Then Why Do You Ignore the Mortgage You Owe The Government On Your Portfolio? Doing so causes some VERY BAD Decisions

31. ©Copyright Financeware, Inc. 2002 All rights reserved PAGE 31 Uninformed or Psychologically Driven Tax Avoidance Why would investors take these risks, just to avoid taxes? Causes of Concentration Risk “But I Don’t Want To Pay The Taxes”… “I’ll Lose 20% To The Government” BUT… YOUR STOCK IS ONLY WORTH WHAT YOU CAN CONVERT IT INTO CASH: » Taxes You Owe Do Not Show Up On Your Account Statement » What a Stock is Worth TO YOU, depends on How Much You Would Have to Pay In Taxes To Convert It Into CASH Taxes Are Like A Debt You Owe When Calculating The Value of your Net-worth, Do You Ignore The Mortgage On Your Home? Then Why Do You Ignore the Mortgage You Owe The Government On Your Portfolio? Doing so causes some VERY BAD Decisions… Like Harry… Avoid TaxesPay Taxes

32. ©Copyright Financeware, Inc. 2002 All rights reserved PAGE 32 Employee Benefit Plans that Encourage Company Stock Ownership ERISA was passed in the early 70’s (Employee Retirement Income Security Act) It required retirement plan fiduciaries to invest “prudently” Which means to diversify And, avoid conflicts of interest Then why are so many retirement plans heavily invested in company stock? Causes of Concentration Risk

33. ©Copyright Financeware, Inc. 2002 All rights reserved PAGE 33 Employee Benefit Plans that Encourage Company Stock Ownership ERISA was passed in the early 70’s (Employee Retirement Income Security Act) It required retirement plan fiduciaries to invest “prudently” Which means to diversify And, avoid conflicts of interest Then why are so many retirement plans heavily invested in company stock? ERISA had a loophole… It specifically permitted retirement plans (particularly ESOP plans) to invest some or all of the money in the stock of the company Of course, some plans (like non-qualified deferred compensation plans) are excluded from ERISA prudent investor rules Causes of Concentration Risk

34. ©Copyright Financeware, Inc. 2002 All rights reserved PAGE 34 Employee Benefit Plans that Encourage Company Stock Ownership ERISA was passed in the early 70’s (Employee Retirement Income Security Act) It required retirement plan fiduciaries to invest “prudently” Which means to diversify And, avoid conflicts of interest Then why are so many retirement plans heavily invested in company stock? ERISA had a loophole… It specifically permitted retirement plans (particularly ESOP plans) to invest some or all of the money in the stock of the company Of course, some plans (like non-qualified deferred compensation plans) are excluded from ERISA prudent investor rules The result is millions of employees have retirement incomes dependent on investments that any prudent investor would avoid 2 In a study done by Financeware of over five-thousand investors, the average investor had only a 50% chance of meeting their financial goals 2 The complete 21 page report can be downloaded free from here: “Living Life on the Flip of a Coin” Causes of Concentration Risk

35. ©Copyright Financeware, Inc. 2002 All rights reserved PAGE 35 How to Avoid the Same Fate as Enron’s Investors The Financeware study showed that is improving investors’ odds of meeting their financial goals: The complete 21 page report can be downloaded free from here: “Living Life on the Flip of a Coin” Correcting concentration risk to confidently achieve financial goals *Based on Financeware study of over five- thousand investors

36. ©Copyright Financeware, Inc. 2002 All rights reserved PAGE 36 How to Avoid the Same Fate as Enron’s Investors is a new investment advisory discipline It not only exposes, manages and controls concentration risk Correcting concentration risk to confidently achieve financial goals

37. ©Copyright Financeware, Inc. 2002 All rights reserved PAGE 37 How to Avoid the Same Fate as Enron’s Investors is a new investment advisory discipline It not only exposes, manages and controls concentration risk It helps investors to: 1.Confidently achieve their most important financial goals 2.Eliminate undue compromises to their financial lifestyle 3.Avoid unnecessary investment risk Correcting concentration risk to confidently achieve financial goals

38. ©Copyright Financeware, Inc. 2002 All rights reserved PAGE 38 How to Avoid the Same Fate as Enron’s Investors is a new investment advisory discipline It not only exposes, manages and controls concentration risk It helps investors to: 1.Confidently achieve their most important financial goals 2.Eliminate undue compromises to their financial lifestyle 3.Avoid unnecessary investment risk In Summary… While the Enron crisis has been devastating The risk is present regardless of scandals and bankruptcy Millions of investors are accepting this risk every day (usually unknowingly) With proper advice and analysis this risk can be avoided This is the future of investment advice… Correcting concentration risk to confidently achieve financial goals