F1 – Project-Stage 13: Personal Investing

TCHE322
Lawrence et al (2011). Chapters 11, 12, 13
CFA Level III Volume 1, 4
Tillery & Tillery (2017). Chapter 10, 18
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Personal finance planning
Personal finance planning process

1. Define financial goals.

2. Develop financial plans and strategies to achieve goals.

3. Implement financial plans and strategies.

4. Periodically develop and implement budgets to monitor and

control process toward goals.

5. Use financial statement to evaluate results of plans and

budgets, taking corrective action as required.

6. Redefine goals and revise plans and strategies as personal

circumstances change.
Essential Information of personal financial plans *
1. A summary of the goals
• Asset acquisition
2. Significant assumptions and justification • Liability and insurance
• Savings and investment
3. Estimates • Employee benefit
4. Recommendations • Tax
• Retirement and estate
5. A description of limitations on the work performed
6. The recommendations in the engagement should contain qualifications to the
recommendations if the effects of certain planning areas on the client’s overall
financial picture were not considered.

* Adapted from Paragraph .35, Statement on Standards in Personal Financial Planning Services No. 1

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Schedule of lectures

Project topic covered

• Investment planning process
• Asset allocation
Groupwork project activities
• Stock/bond/other financial assets and real estate analysis
• Managing risk

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Investment planning process
The monitoring
engagement phase
The implementation
phase
The planning phase

Determine and prioritize client’s specific financial goals

Refer to stage 4
Client’s financial condition
Refer to stage 6
Assessing risk tolerance
Identify unique needs
Identify potential client investment constraints and requirements
 investment policy statement
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Investment
Policy
Statement

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Assessing risk tolerance
 Two common methods: A risk tolerance questionnaire or a psychometric test

• A risk tolerance questionnaire is the norm for most personal financial

planners.
E.g.: Investor Profile Questionnaire from Schwab
https://www.schwab.com/resource/investment-questionnaire

• Another type of risk tolerance assessment tool is a psychometric test.

Refer to Financial risk tolerance: A Psychometric Review

 Some determinants of risk tolerance

 E.g.: Thanki & Baser (2021) (https://www.pm-research.com/content/iijwealthmgmt/24/2/48)

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Assessing risk tolerance
• There are several methods to assess a client’s risk tolerance. No one method is mandated. Many
personal financial planners determine their client’s risk tolerance through conversation. These
planners are adamant that their knowledge and experience creates a better asset allocation
model than the computerized tools that have been created to assess the client’s attitude toward
risk.
• A risk tolerance questionnaire is the norm for most personal financial planners. The typical
questionnaire has between 5 and 10 questions. Basic questions address time horizon and basic
knowledge of investments. Each of the questions generates a type of numeric score. The sum of
the values is tabulated, and a hypothetical asset allocation is proposed.
• Another type of risk tolerance assessment tool is a psychometric test. These tests are extensive
and usually require 30–40 minutes to complete. The client is measured against a demographic
pool of respondents. The result is often an asset allocation model based on the efficient frontier
and the client’s indifference curve.

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Investor Attributes
• Investors are classified into various groups based on:
• Tolerance to risk
• Preference for income versus capital growth
• Investment timeframe
• Defensive investors are more risk averse and are focused on preserving capital
• Aggressive investors have more tolerance towards risk and focus on capital
growth
• Financial planners use these classifications to determine the appropriate asset
mix for their clients

o A person’s age
o Income
Risk Profile o Wealth
o Years to retirement
o Past financial experiences
General Investor Attributes – By Classification
Traditional balance sheet versus Economic (Holistic) balance sheet

Pension value: The mortality-weighted

net present value at Time 0 (now)

Where r: discount rate

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 Asset allocation and financial asset allocation decision
• The allocation of the different asset types will affect the optimal
financial asset allocation decision.

• A 45-year- old individual with $1 million in human capital and $500,000 in

investment assets.
• A 45-year- old with $3 million in human capital and an identical $500,000 in
investment assets.
• Both individuals have a 40-year planning horizon
• Both have the same level of risk tolerance.
• Whose investment portfolio tends to be less conservative?

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Identify unique needs/unique constraints

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Identify potential client investment constraints
• Liquidity: Before a client begins an investment plan, emergency reserves should
be established.
• Time Horizon
• Tax status
• Human Capital Risks: are those risks unique to an investor’s ability to work, or to
the investor’s susceptibility to premature death or disability.
refer to stage 9: risk management for individual.
pension benefit Morbidity (disability due to injury or illness) and mortality
(premature death) need to be addressed in the IPS.
Documentation regarding sufficient insurance to address the risk of economic
loss should be included.
If there is none, investment assets will have to be utilized to address the
economic loss and may affect how certain assets are invested.
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Identify potential client investment requirement
• Should assets be managed with consideration given to ESG issues?

• Are there any legal and regulatory factors that need to be considered?

• Are any political sensitivities relevant?

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 Assets allocation
Asset allocation is a strategic, and often a first or early, decision in portfolio construction.
• General Investment Strategies:
 Gibson (2000)* argued that holding four asset classes in a portfolio (multiple-asset
class investing) would reduce the risk of the portfolio and increase its average
return.
• This happens because the four asset classes are not strongly related to each other:
• As one asset class performs well the others are less likely to perform as well and as
the better performing asset class reverses its performance the other asset classes
tend to perform better.
• The performances tend to counteract each other which provides for a better long
term average return and lower level of risk of such a portfolio.

* Gibson, R. C. (2004). The rewards of multiple-asset-class investing. Journal of Financial Planning, 17(7), 58.
Traditional Approaches to Asset Classification
A Liquidity-Based Approach to Defining the Opportunity Set
 Traditional Approaches to Asset Classification
An Approach Based on Expected Performance under Distinct Macroeconomic Regimes

Capital growth assets would be expected to benefit from

healthy economic growth.

Inflation-hedging assets—so-called “real assets” such as

real estate, commodities, and natural resources but also
inflation-linked bonds—would be expected to outperform
other asset classes when inflation expectations rise, or
actual inflation exceeds expectations.

Deflation-hedging assets (e.g., nominal government bonds)

would be expected to outperform most of the other asset
classes when the economy slows, and inflation becomes
very low or negative.
Source: CFA Level III Volume 4
Considering diversification
• Returns on various assets are impacted by the broader economic environment
in different ways
• Diversification is owning/investing in more than one particular asset, and more
than one asset class.
• The goal of diversification is to minimise risk
Illustrating how diversification can reduce risk in a portfolio of shares

• The correlation coefficient shows the extent of correlation among shares

• It has a numerical value of –1 to +1 which indicates the extent of risk reduction
within a portfolio:
Negative correlation (–1) -> Large risk reduction
Positive correlation (+1) -> No risk reduction
Diversification Across Asset Classes
Selection of a strategic asset allocation
 Having objectives and other inputs in the planning phase
 Determine the approach to asset allocation that is most suitable for the investor.
 Specify asset classes and develop a set of capital market expectations for the specified asset
classes.
 (1)Develop a range of potential asset allocation choices for consideration. These choices are often
developed through optimization exercises. Specifics depend on the approach taken to asset
allocation.
 Test the robustness of the potential choices. This testing often involves conducting simulations to
evaluate potential results in relation to investment objectives and risk tolerance over appropriate
planning horizon(s) for the different asset allocations developed in (1). The sensitivity of the
outcomes to changes in capital market expectations is also tested.
 Iterate back to (1) until an appropriate and agreed-on asset allocation is constructed.
Assets allocation
Asset allocation is a strategic—and often a first or early—decision in portfolio construction.
Three broad approaches to asset allocation:
(1) asset-only approaches to asset allocation: focus solely on the asset side of the investor’s
balance sheet.
 Mean–variance optimization (MVO) is the most familiar and deeply studied asset-only
Approach MVO considers only the expected returns, risks, and correlations of the asset
classes in the opportunity set.
(2) liability-relative approaches to asset allocation: choose an asset allocation in relation to the
objective of funding liabilities.
 Liability-driven investing (LDI) is an investment industry term that generally encompasses
asset allocation that is focused on funding an investor’s liabilities.
(3) goals-based approaches: involve specifying asset allocations for sub-portfolios, each of
which is aligned to specified goals, are used primarily for individuals and families.
Three approaches to assets allocation

Overview of Finance 24
 Developing asset-only asset allocation
Mean-variance optimization
Mean–variance optimization introduced by Markowitz (1952, 1959), is perhaps the most common
approach used in practice to develop and set asset allocation policy.

Mean–variance optimization: a framework for determining how much to allocate to each asset in
order to maximize the expected return of the portfolio for an expected level of risk.

Note:
E(Rm) and σm are expressed as
percentages rather than as decimals.

Time Horizon: “single-period” framework

 Mean-variance optimization: Case
John Tomb is an investment advisor at an asset management rm. He is developing an asset allocation for
James Youngmall, a client of the rm. Tomb considers two possible allocations for Youngmall.
Allocation A consists of four asset classes: cash, US bonds, US equities, and global equities.
Allocation B includes these same four asset classes, as well as global bonds.
Youngmall has a relatively low risk tolerance with a risk aversion coefficient of 7. Tomb runs mean–
variance optimization (MVO) to maximize the utility function to determine the preferred allocation for
Youngmall.

Determine which allocation in

Exhibit 1 Tomb should recommend
to Youngmall. Justify your response.
 Mean-variance optimization: Case
An investment adviser is counseling Aimee Goddard, a client who recently inherited €1,200,000 and
who has above-average risk tolerance (λ = 2). Because Goddard is young and one of her goals is to fund
a comfortable retirement, she wants to earn returns that will outpace inflation in the long term.
Goddard expects to liquidate €60,000 of the inherited portfolio in 12 months to fund the down payment
on a house. She states that it is important for her to be able to take out the €60,000 without invading
the initial capital of €1,200,000. Exhibit shows three alternative strategic asset allocations.

a. Based only on Goddard’s risk-

adjusted expected returns for the
asset allocations, which asset
allocation would she prefer?
b. Recommend and justify a strategic
asset allocation for Goddard.

Probability of exceeding the minimum RL given a normal return distribution assumption

Evaluating the robustness of an asset allocation
MONTE CARLO SIMULATION
Monte Carlo simulation complements MVO by addressing the limitations of MVO
as a single-period framework.
In the case in which the investor’s risk tolerance is either unknown or in need of
further validation, Monte Carlo simulation can help paint a realistic picture of
potential future outcomes, including the likelihood of meeting various goals,
the distribution of the portfolio’s expected value through time, and potential
maximum drawdowns.
Simulation also provides a tool for investigating the effects of trading/rebalancing
costs and taxes and the interaction of evolving financial markets with asset
allocation.
How to run Monte Carlo simulation? Part 1 Part 2
 MONTE CARLO SIMULATION: Case Malala Ali
Objectives: median value of her bequest to
her children to be no less than her portfolio’s
current value of CAF$1 million in real terms.
The median is the 50th percentile outcome.

Is the current asset allocation expected to

satisfy Ali’s investment objectives?
Developing goals-based asset allocation
THE GOALS-BASED ASSET ALLOCATION PROCESS
Information Sources for Investment Choices
• Economic fundamentals
• Industry characteristics and reports
• Company background, prospects, annual reports
• Current market prices
• Government reports
• Analyst reports
• Using the internet as a search engine