Investing Guide

With 5 weeks left, I need to ramp up my studying. I’ve read through the CFA curriculum, Schweser Study notes, watched the Schweser Video Lectures (40 hours), went to the 3 day seminar, and gone through the flash cards. I’ve reviewed CFAI 2000-2003 exams. My plan is to go over the rest of the CFAI exams. Then I am going to review most of the 2,000+ questions on SchweserPro Qbank. I also need to work on Schweser practice book 1 (3 6 hour practice exams). After that, I am going to do CFAI practice exams and do the Schweser problem practice workshop and 3 more Schweser online practice exams. I hope I’ll be ready by then. Wish me luck.

I’m attending the Schweser 3 day seminar this weekend. It’s Saturday now and I’ve gone to 2 out of the 3 days. This year’s level 3 seminar was not as helpful as the last year’s seminar for level 2. The instructor is Erik Benrud. Although he knows his material, he went over the seminar workbook slides 80% of the time. I was hoping to learn more exam strategies. I did get 1 helpful tip so far and it is to only write down what is required. If a question asks for 1 answer explanation, do not give 3 or 4 answers. The $430 is a sunk cost, so I’m going to make the most out of the last day. At least the seminar forces me to put in some more hours, but it is killing my weekend.

Individuals may sometime need to change the systematic (beta) exposure of their portfolio.  One can use futures to adjust the Beta of a portfolio.  The formula to determine the number of futures contracts needed is:

Number of futures position = (Beta target - Beta of Portfolio) * Market value of Portfolio / Price of futures contract

If an investor had a 1 million dollar portfolio with 60% stocks index and 40% bond and wanted to convert their allocation to 50/50 stocks and bond, they would need to convert 100,000 of their stock position to cash by shorting the appropriate amount of stock index futures.

Let’s say the stock index futures contract price is 2,500 with a beta of 1.  The stock portfolio has a beta of 0.85.  Using the formula:

(0 - .85)/1 * 100,000/2,500 = -34 contracts.  In order to convert the 100,000 portion of the stock index to cash, we would need to short 34 stock index futures.  With the synthetic cash, we will now convert the cash into the bond position by going long on a bond index futures.

The formula for calculating the number of bond futures to essentially the same as the stock index formula except we replace beta with modified duration.

(Modified duration Target - Modified Duration Portfolio) * Mv of Bond/ future price

If the modified duration of the portfolio = 6, bond index duration = 7, bond index price is 1,250, we can now figure out how many bond futures position to go long.

(6 - 0)/7 *100,000/1,250 = 68.57.  The 100,000 has a duration of zero because it is the synthetic cash that we converted from the stock portfolio.

Using futures may be a cheaper alternative than buying and selling positions, especially if an investor does not want to delay capital gains taxes.  Investors can choose to hold cash and create a synthetic stock position by going long futures if liquidity is a concern.  Using futures may be a good use for someone employing tactical asset allocation.

Companies usually immunize their liabilities by matching duration or cash flow. 

If duration of the portfolio < liability duration, there will be reinvestment risk-the risk of losing money when interest rates fall because the price increase will be less than the reinvested coupons.

If duration of the portfolio > liability duration, there will be price risk-the risk that the loss of principal when interest rates rise because the loss in price is more than the gain on the reinvested coupons.

Duration changes when interest rates fluctuate and as time passes.  One must weigh the transaction costs with the benefits of rebalancing a portfolio.

To avoid immunization risk (assets and liabilities changes do not match) portfolio managers can try to minimize cash flow dispersion around the maturity date by using bullets and barbell strategies. 

My brother is making money collecting Morgan Silver Dollar coins.  He would buy a lot of them and collect or sell the ones he doesn’t need.  The key to making a lot of money is specialized knowledge.  It takes time and research to learn.  Learning how to tell what grade a coin is a very good skill to have.  Some old people who have been collecting coins for 40 years practice by looking at thousands of coins.  The rarer coins (lower circulation) and how mint a coin determines its price.  There is a lot of money to be made if you are into collecting coins.  Buying coins with a margin of safety is always a good idea. 

Whether retirement is looming large on your horizon or not, your financial future is something that you need to think about today. In fact, waiting even until you are 30 years of age to begin building your future and practicing sound financial planning can have detrimental effects. Financial planning for wealth should begin as early as possible, for the best results.

The first step towards sound financial planning is to live below your means. Simply because you have the income to live at a certain level, does not mean that you have to. Using that surplus capital to invest in diversified options is the best way to begin growing your wealth for future financial security.

Financial planning should be practiced throughout your life and can encompass a wide variety of different practices. Investing your capital in slow growth, steady investments are the best way to assure your future financial health. Speculative investments can pay off well, also, but they should be regarded with some skepticism.

In addition, the development of a sound financial planning strategy cannot be overlooked. The single clarion call in this is diversification. The more diverse your investments, the better your investing will pay off in the end. Another key part of sound financial planning is to leave your investments alone. Let them grow, invest the dividends and pretend that they don’t exist. This way, you can build a substantial amount of net worth, without feeling as though you are investing money that you and your family need to live on.

I just used Morningstar’s X-Ray Tool to see the composition of my portfolio.  I have not done that in awhile and my allocations has changed a lot since the last time.  This is due to the my 401k contributions.  My 401k uses proprietary mutual funds that track the S&P 500, Russell 2000, Lehman Aggregate Bond, and Morgan Stanley EAFE indexes.  I have used proxy index funds for the Morningstar X-Ray inputs. 

Here is the makeup of my portfolio:

Cash  5.12%

U.S. Stocks 41.88%

Foreign Stocks 44.53%

Bonds 8.21%

Morningstar’s Style Box

Value / Core / Growth

23/25/23 Large

8/5/4 Med

5/3/3 Small

Most of my holdings are mutual funds.  The estimated yearly mutual fund expense ratio is at .79%.  This amounts to an estimated mutual fund expense of 635.82.  I have index funds in my 401k, American Funds in my Roth and Oakmark Funds in my taxable accounts.  This is not the best asset location and I plan to change it soon. 

My top holdings include:

26.86% OAKWX - Oakmark Global Select (Taxable Account)

9.36% CWGIX - Capital World Growth and Income (Roth)

9.13% Morgan Stanley EAFE Index (401k)

8.24% S&P 500 Index (401k)

6.58% Russell 2000 Index (401k)

6.37% Lehman Aggregate Bond Index (401k)

6.11 OAKEX - Oakmark International Small Cap Index (Taxable Account)

6.10 NEWFX - American Funds New World (Roth)

5.85 SMCWX - American Funds Small Cap World (Roth)

5.5 CAIBX - American Funds Capital Income Builder (Roth)

I plan on getting rid of SMCWX and CAIBX to get more shares of NEWFX and CWGIX.  I need to consolidate my holdings.  OAKEX is very tax inefficient.  It is not a good idea for me to hold it in a taxable account; especially when it can distribute as much as 20% of its NAV.  I usually like to keep my accounts as separate wholes, but it is a better idea to treat all of my account as a whole.

This is a continuation post from the previous IPS article called Creating IPS.  The first article went over the risk and return objectives.  This post will describe the 5 constraints in an IPS. 

The 5 constraints in an IPS are LLUTT:
Legal and Regulatory
Liquidity
Unique cirumstances
Time Horizon
Taxes

Individual investors do not have many legal and regulatory restrictions as institutional investors such as banks, insurance companies, endowments, foundations and corporations.  This section applies to trusts and family foundations.

Liquidity is the ability to meet an investor’s anticipated and unanticipated distributions.  Liquidity affects a portfolio’s ability to take risk.  Portfolios with low liquidity requirements can invest in riskier assets.  They can also bear more risk because they do not have to raise cash or set aside large sums of money to cover the liquidity needs.  The liquidity requirements include living expenses, emergency reserves and future liquidity events such as a future home purchase.  Investors should be aware of illiquid holdings such as homes.  Most investors do not include their primary residence as part of their portfolio because they do not plan on selling it.

Unique circumstances are based on the investors’ preferences.  They can restrict the portfolio from holding tobacco, firearms or alcohol stocks.  Other unique circumstances can include low cost basis stocks.

Time horizon can be single stage or multistage, which is the most common.  The three common time horizons include: accumulation, retirement and post retirement.  The most common multistage time horizon for a young investor is the accumulation and retirment.  Investors need to save up enough money so that their portfolio can support their expenses without the help of working income. 

Taxes are an important consideration for investors.  Tax avoidance and deferral are should be used when constructing a portfolio, but not tax evasion- which is illegal.  Efficient tax location should be utilized to maximize after-tax returns.  Treat every account as part of the portfolio.  Place tax inefficient holdings such as bonds and REITs in tax sheltered accounts.  Stocks and tax efficient index funds should be place in taxable accounts. 

These 5 constraints and risk and return objectives make up the IPS.  The IPS should be revisited at least annually and updated when an investor’s situation changes(New home purchase, retirement, marraige, etc).

Investors should create an investor policy statement (IPS) before constructing their portfolio. An IPS consists of risk and return objectives along with 5 constraints: liquidity, legal and regulatory environment, unique circumstances, taxes and time horizon. A good way to remember the constraints is to use the acronym LLUTT.

Before forming the risk and return objectives, an investor define their circumstances and goals. We need to know the investor’s net worth, income and expenses to figure out what the risk and return requirements are. There is required rate of return and desired rate of return. Required rate of return is the refers to amount needed to fund primary goals such as retirement or a child’s college education. The desired rate of return refers to secondary goals such as a vacation home purchase, another car or luxury goods and services. All the return requirements should be adjusted to account for tax and inflation. For example, a nominal return requirement of 4% with 3% inflation and a 25% marginal tax bracket would require an 8.33% return. (4%/.75 + 3%) Return requirement must take into account the risk tolerance of the investor.

Risk tolerance can be broken down into willingness to take risk, ability to take risk, and the overall risk tolerance. Willingness to take risk depends on an investor’s behavior and risk tolerance. For example, entrepreneurs are usually more willing to take risk. Ability to take risk is based on the individual’s goals, expenses, time horizon and asset base. The overall risk incorporates the ability and willingness to take risk and choses the less risk tolerant option. For example if the willingness to take risk is above average, but the ability to take risk is below average, then the overall risk will be below average.

I will write about the 5 constraints in the next post.

Wamu Statement Savings account dropped to 4.25% from 4.75%. Expect further drops after the Fed lowers interest rates again on January 30th, 2008. Here is a link to Fatwallet that shows the highest savings account available. Check this forum whenever you want to find out who pays the highest interest rates.