Chapter 2


The Inger family resides in a politically stable country whose
currency trades at a fixed exchange of 1:1 with the euro. Both
real GDP growth an inflation average about 3% annually, resulting
in nominal annual growth of about 6%. The country maintains a
flat tax of 25% on all personal income and a net capital gains tax
of 15%, with no distinction between ST and LT holding periods.
The code also has a wealth transfer tax where any asset transfer
between 2 parties is taxed at a flat rate of 50%.
Their country maintains a national pension plan but there is
uncertainty about its viability. Due to questions about the
financial security of future retirees, the country has created selfcontributory, tax-advantaged investment accounts for
individuals. Taxpayers may contribute up to €5,000 of after-tax
income to retirement savings accounts. The returns are exempt
from taxes and participants can make tax-free withdrawals of
any amount at age 62.


The family has no IPS or stated guidelines. Peter and Hilda have
been married for 37 years and have two children, Christa, aged
25, and Hans, aged 30. Peter is 59 and a successful entrepreneur
who founded a boat manufacturing business when he was 23. He
built the company which now sells luxury boats worldwide but is
considering a succession plan and retirement. Peter wants to
monetize his equity stake and believes he can sell the company
in the next 3 months. He is evaluating 3 bids that indicate
probable proceeds, net of taxes on gains, of €55 million to the
family in total. The 4 family members are the sole shareholders
and money will accrue to them in proportion to their % ownership
stake.
Hilda is 57 and comes from a wealthy family. She is the
beneficiary of a trust established by her family. Throughout her
lifetime her trust will distribute to her an inflation-indexed
annual payment (currently €75,000) which is taxed as personal
income. At her death, the payments will stop and the remaining
money will go to a local charity.

Hans and Christa are both unmarried. Hans is a senior VP at
IngerMarine and specializes in boat design. Peter has tried to
involve Christa but she has resisted and achieved moderate
recognition and financial success as an artist. Christa has a 5
year old son whom she is raising alone.

Situational – characterize individual investors
by stage of life or by economic circumstance
◦ source of wealth
◦ measure of wealth
◦ stage of life

Foundation stage:

Accumulation stage

Maintenance stage (early retirement)

Distribution stage

Life events can send an investor backward (new career or
family) or forward (injury or illness) to a different stage
◦ Establishes base for wealth creation (skill, education, business
formation)
◦ Relatively young, long time horizon, increased ability to accept risk
◦ Need for liquidity may outweigh risk tolerance
◦ Rising income and expenses (marriage, children, home)
◦ Later income still rises but expenses decline (children grow up, home
paid off), increasing ability to save
◦ Increased wealth and still-long time horizon increase risk tolerance
◦ Need to maintain lifestyle and financial security
◦ Shorter time horizon, less risk tolerance
◦ Some risky assets needed to preserve purchasing power
◦ Gifting to heirs or charities
◦ Tax constraints require early planning
Net Worth
Accumulation
Phase
Long-term:
Retirement
Children’s
college
Short-term:
House
Car
25
Figure 2.1
Consolidation Phase Spending Phase
Gifting Phase
Long-term:
Retirement
Long-term:
Estate
Short-term:
Planning
Vacations
Short-term:
Children’s College
Lifestyle
Needs Gifts
35
45
55
65
Age
75




Personality plays an important role in
establishing investor’s risk tolerance and
return objectives
Bridges the gap between traditional finance
and behavioral finance
Traditional finance measures objective
circumstances, and assumes investors are risk
averse, hold rational expectations and practice
asset integration (portfolio context)
Behavioral finance assumes investor
psychology leads investors to be loss averse,
hold biased expectations and practice asset
segregation (each asset viewed independently)

Investors are loss averse

Investor expectations are biased

Investors segregate assets

◦ Do not view risk as uncertainty but rather as the potential for
gain or loss
◦ More weight placed on losses than on gains
◦ Actually seek risk to avoid a certain loss even when resulting in
lower expected value
◦ Overconfident about future predictions
◦ Overestimate significance of rare events and the
representativeness of one asset for another
◦ Do not consider interaction
◦ Segregate into mental accounts by purpose or preference
To accommodate behavior, portfolios should be constructed
to include subjective constraints and be layered to reflect
asset segregation (with the layers forming an integrated
whole).
1. Policy statement - Focus: Investor’s short-term
and long-term needs, familiarity with capital
market history, and expectations
2. Examine current and project financial, economic,
political, and social conditions - Focus: Short-term
and intermediate-term expected conditions to use
in constructing a specific portfolio
3. Implement the plan by constructing the portfolio Focus: Meet the investor’s needs at the minimum
risk levels
4. Feedback loop: Monitor and update investor
needs, environmental conditions, portfolio
performance

The Smith Family Portfolio’s primary focus is the
production of current income, with long-term capital
appreciation a secondary consideration. The need
for a dependable income stream precludes
investment vehicles with even modest likelihood of
losses. Liquidity needs reinforce the need to
emphasize minimum-risk investments. Extensive
use of short-term investment-grade investments is
entirely justified by the expectation that a lowinflation environment will exist indefinitely into the
future. For these reasons, investments will
emphasize U.S. Treasury bills and notes,
intermediate-term investment-grade corporate debt,
and select “blue chip” stocks whose dividend
distributions are assured and whose price
fluctuations are minimal.

For Clients:
◦ Educational process
◦ Reduces need to blindly trust adviser
◦ Portable document if change in advisers or second
opinion is necessary

For advisers:
◦ Protects adviser
◦ Can clarify motivation for decisions
◦ Can help identify questionable situations before
they become serious
Inger Family Data
Income (annual)
€ 500,000
Peter salarya
Hans salary
100,000
expects to receive a fixed annual pmt of €100,000
Hilda trust payment
75,000
aPeter
Christa (art sales)
50,000
taxable as income from the IM pension plan starting in 5 yrs.
bIM
Peter Personal Assets
Home (paid for and jointly held)
IngerMarine company
equityb
Diversified equity securities
equity values are pretax market values; the equity has
€ 1,200,000
a zero cost basis for purposes of taxation on capital gains.
60,000,000
The company pays no dividend.
750,000
Fixed income securities
1,000,000
cBeginning
Cash (money market fund)
1,000,000
distribution of approximately €5,000 (tax exempt).
Gold bullion
500,000
RSAc
50,000
Hilda Personal Assets
IngerMarine company equityb
€ 1,200,000
Hans Personal Assets
Home (net of mortgage)
IngerMarine company
equittyb
€ 200,000
2,400,000
Diversified equity securities
200,000
Cash (money market fund)
100,000
Christa Personal Assets
IngerMarine company equittyb
€ 1,200,000
Balanced mutual funds
75,000
Cash (money market fund)
25,000
at age 62, Peter plans to take a fixed annual

differentiate between return requirement and
return desire
◦ for example, the Inger’s current needs are being met by
Peter’s salary of €500,000
◦ if IngerMarine is sold, they may require a return that
replaces Peter’s salary – critical objective
◦ they may desire a return that accommodates their major
acquisitions and will leave the children financially secure
- important but less critical objective

investor who has retirement goals that are
inconsistent with current assets and risk
tolerance may need to:
◦ move back date of retirement
◦ accept reduced standard of living
◦ increase current savings
Current
1
2
3
4
5
79,568
81,955
84,413
86,946
Inflows
Salary (taxed as income)
Trust pmt (taxed as income)
500,000
75,000
77,250
Pension (taxed as income)
100,000
RSA (tax-free)
Sale of firm (taxed as gain)
Total Inflows
5,000
5,000
5,000
61,200,000
575,000
61,277,250
79,568
86,955
89,413
191,946
-143,750
-19,313
-19,892
-20,489
-21,103
-46,737
-15,000
-15,450
-15,914
-16,391
-16,883
-7,500
-7,725
-7,957
-8,196
-8,442
Outflows
Income tax (25%)
Gains tax (15%)
-9,180,000
Second home
-7,000,000
Inv. in magazine
-5,000,000
Support for Jurgen
Transfer tax on support (50%)
Living and Misc. expenses
-500,000
-515,000
-530,450
-546,364
-562,754
-579,637
Total Expenses
-643,750
-21,736,813
-573,517
-590,724
-608,444
-651,699
-68,750
39,540,437
-493,949
-503,769
-519,031
-459,753
Net Additions/Withdrawals
inflation assumed at 3% annually
Investable Assets, Net Worth, and Required Returns
Investable Assets
Amount
% of Net Worth
€ 39,540,437
77%
750,000
1%
Fixed-income Holdings
1,000,000
2%
Cash Equivalents
1,000,000
2%
50,000
0%
€ 42,340,437
83%
€ 1,200,000
2%
7,000,000
14%
Total
€ 8,200,000
16%
Gold
€ 500,000
1%
€ 51,040,437
100%
€ 493,949
1.17%
Year 1 CF
Stock Holdings
RSA Account
Total
Real Estate
First Home
Second Home
Net Worth
Required Return
Distributions in Year 2
Divided by Investable Assets
Plus Expected Inflation
€ 42,340,437
3%
4.17%

ways to determine risk objectives may differ
but all must address these questions
(quantitative measure is most appropriate)
◦ What are the investor’s financial needs and goals,
both long term and short term?
◦ How important are these goals? How serious are the
consequences if they are not met?
◦ How large an investment shortfall can the investor’s
portfolio bear before jeopardizing its ability to meet
major short- and long-term investment goals?



income tax - % of total income
capital gains tax – tax on price appreciation
that comes when asset has been sold
wealth transfer tax – tax due when assets
have been transferred but not sold
◦ estate taxes
◦ gift taxes

property tax – tax on real estate (sometimes
on financial assets)






Universal and complex
◦
◦
◦
◦
Income tax
Gains tax (profits on investments)
Wealth transfer tax (gift or estate taxes)
Property tax (real or financial property)
Investment plans must be based on after-tax
perspective
Tax deferral – more frequent periodic payments
diminish wealth, so some plans try to defer tax
payment as long as possible
Tax avoidance – tax exempt investments typically
come at expense of lower returns, liquidity or control
Tax reduction – different rates for income or gains
Wealth transfer – Early transfers (pre-death) may be
desirable and also may result in longer tax deferral
Figure 2.5
Investment
Value
$10,063
8% Tax
Deferred
$5,365
5.76%
After Tax
Return
$1,000
0
10
20
Time
30 years
Effect of Taxes on Portfolio Performance
Periodic 25% Tax
Year
Beg. Value
Returns
(Tax 25%)
End Value
Cum. Gain
1
100,000
10,000
2,500
107,500
7,500
2
107,500
10,750
2,688
115,563
15,563
3
115,563
11,556
2,889
124,230
24,230
4
124,230
12,423
3,106
133,547
33,547
5
133,547
13,355
3,339
143,563
43,563
Cumulative 25% Tax
Year
Beg. Value
Returns
(Tax 25%)
End Value
Cum. Gain
1
100,000
10,000
n/a
110,000
10,000
2
110,000
11,000
n/a
121,000
21,000
3
121,000
12,100
n/a
133,100
33,100
4
133,100
13,310
n/a
146,410
46,410
5
146,410
14,641
n/a
161,051
61,051
Less 25% Tax
15,263
145,788
45,788

Regular IRA - tax deductible
◦ withdrawals taxable

Roth IRA - not tax deductible
◦ tax-free withdrawals possible


Annuities
Employer’s 401(k) and 403(b) plans


need to find asset class weights consistent
with return objective, risk tolerance, and
constraints
complete from a taxable perspective
considering:
◦ after-tax returns
◦ tax consequences of shift from current portfolio
allocation
◦ impact of future rebalancing
◦ asset “location”
 ie, nontaxable investments should not be “located” in
tax-exempt accounts

Selecting the most satisfactory asset
allocation for an investor consists of
four steps.
1. Determine asset allocations that meet
return requirement (total, after tax return)
2. Eliminate allocations that fail to meet
quantitative risk objectives or are
inconsistent with investor risk tolerance
3. Eliminate allocations that fail to satisfy
other investor constraints
4. Select from remaining allocations that which
offers the best risk-adjusted performance
and diversification
Exhibit 2-9 Proposed Asset Allocation Alternatives
Asset Class
Projected
Expected
Total Return
σ
Cash Equivalents
4.50%
2.50%
Corporate Bonds
6.00%
11.00%
Municipal Bonds
7.20%
10.80%
Large-cap US Stocks
13.00%
17.00%
Small-cap US Stocks
15.00%
21.00%
International Stocks (EAFE)
15.00%
21.00%
REITs
10.00%
15.00%
Venture Capital
26.00%
64.00%
Total
A
10%
0
40
20
10
10
10
0
100%
B
20%
25
0
15
10
10
10
0
100%
Allocation
C
25%
0
30
35
0
0
10
0
100%
D
5%
0
0
25
15
15
25
15
100%
E
10%
0
30
5
5
10
35
5
100%
Allocation
Summary Data
A
B
C
D
Expected Total Return
9.90%
11.00%
8.80%
14.40% 10.30%
Expected AT Total Return
7.40%
7.20%
6.50%
9.40%
Expected Standard Deviation
9.40%
12.40%
8.50%
18.10% 10.10%
Sharpe Ratio
0.574
0.524
0.506
0.547
E
7.50%
0.574
Exhibit 2-10 Asset Allocation Alternatives: Nominal and Real Expected Returns
Allocation
Return Measure
A
B
C
D
E
Nominal Expected Return
9.90%
11.00%
8.80%
14.40%
10.30%
Expected Real AT Return
3.40%
3.20%
2.50%
5.40%
3.50%
Return Requirement – 3% real after-tax
return
1.
◦
2.
◦
3.
4.
allocations A, B, D, and E meet requirement
Risk Tolerance – worst case nominal return
of -10% in any 12 month period
expected return less 2 times σ is good baseline –
allocations A and E meet requirement
Constraints – allocations A and E meet
stated constraints
Risk-Adjusted Performance and
Diversification Evaluation






Creates path-dependent scenarios based on
probability distribution to predict end-stage results
Superior to steady-state (deterministic) forecasting
because incorporates variability across long-term
assumptions and impact of resulting paths on
ending wealth
Generates probability distribution of ending wealth
rather than a single point estimate
Gives insight on trade-off between short-term risk
and long-term failure to achieve objective
Can capture volatility due to varying tax
assumptions
More closely approximates likely investment
outcomes

advantages to using as compared to a
deterministic approach:
1. more accurately portrays the risk-return tradeoff
2. gives information on possible tradeoff between
short-term risk and the risk of not meeting a
long-term goal
3. can capture the variety of portfolio changes that
can potentially result from tax effects
4. better able to model the stochastic process of
calculating future returns and the alternative
outcomes resulting from the process

not all commercially available Monte Carlo
products generate equally reliable results –
things to be aware of:
◦ be wary of simulation tool that relies only on
historical data
◦ choose a product that simulate the performance of
specific investments, not just asset classes
◦ make sure it takes into account the tax
consequences of investments