CFA Level 3 – Book 1 – Behavioral Finance and Private Wealth Management

Traditional Finance (TF) — Focuses on how individual SHOULD behave. Assumes ppl are/have? Such individuals are know as?

Behavioral Finance (BF)– descriptive — focuses on how individuals DO behave and make decisions. Assume ppl are/have? (Bounded rationality ‘*’ vs. Prospect theory ‘**’)

Selfish (utility maximize)
Have perfect information.

Rational economic men

Cognitive limits on decision making*
Reference dependence**
Capacity limits on knowledge*

Rational decision maker follow 4 self evident rules?
-Completeness (need to know preferences)
-Transitivity (consistency across rankings. A>B, B>C, then A>C)
-Independence (rankings are additive/proportional. If D>E, both give utility, then D+E(x), is preferred).
-Continuity (unlimited combination available to make utility equal for 2 goods).
Bayes formula
Rule for updating prior probability of an event.
• Elec Inc, is mulling overseas expansion (O) and price increases (I)
• Probabilities:
o P(I) = .3
o P(not I) = .7
o P(O | I) = .6
o P(O | not I) = .4
• What is new probability of price increase if overseas expansion announced (P(I|O))


Updated prob of an event given new info=
• Prob of new info for a given event / Unconditional prob of new info x Prior probability of event
• P(A|B) =( P(B|A) / P(B)) * P(A)

In this case the old probability is P(I), want to know P(I|O)
o P(I|O) = (P(O|I) / P(O)) * P(I)
Alternate way
P(I), P(not I) = PRIORS
P(IO) = P(O|I) * P(I) – multiplication rule
• P(IO) = P(I|O) * P(O)
P(IO) = .6 * .3
P(IO) = .18
.18 = P(I|O) * P(O)
• P(O) = P(O|I) P(I) + P(O|not I) P(not I)
• P(O) = .6 * .3 + .4 * .7
• P(O) = .18+.28 = .46
.18 = P(I|O) * .46
P(I|O) = .3913

Risk aversion… Describe three types?

Bounded rationality?

Prospect theory? vs Utility theory?

Investment pays out 100 or 200. Average of 150.
-Risk averse. Suffers greater loss of utility for a given loss of wealth, than they gain in utility for the same rise in wealth. Would pay less than 150. Concave utility function (as a function of wealth)
-Risk neutral. Gains or loses give equal utility.
-Risk loving. Would pay >150. Large gains give more utility. Convex utility function (as a function of wealth)

Assumes knowledge capacity limits and removes assumptions of perfect information and rational decisions. INSTEAD SATISFICE — outcomes that offer sufficient, but not optimal unity are sufficient.

Relaxes bounded rationality even further – PROPOSES LOSS AVERSION. Choices are made in 2 phases:
1. Editing phase. Economically identical outcomes are grouped and a reference point identified. (simplify number of choices, risk is reference point drives #2)
2. Evaluation phase. Focus on change in wealth, not resulting level of wealth (i.e. loss aversion).

Utility theory focuses on risk aversion while prospect theory focuses on loss aversion.

Prospect theory:

6 steps of editing phase?
Isolation effect?

1. Codification – codes the proposal as a gain or loss of value and assigns a probability to each possible outcome.
2. Combination – combines identical outcomes.
3. Segregation – separates an expected return into both a risk free and risky component of return. (i.e. payoff is 75% $100 or 25% 150 — risk free is 75% $100)
4. Cancellation – Removes any outcomes common in 2 proposals.
5. Simplification — rounds probability or eliminates very unlikely scenarios.
6. Detection of Dominance – discards any ‘dominated’ proposal (i.e. if A is 100% E(R) = 7% and B is 100% E(R) = 5%, why would you go with B?)

Investors can focus too much on one factor / outcome while ignoring other important factor. i.e. Lottery has payoff 1: 33% of $3000 or nothing or 2: 20% chance of $5,500 or nothing. E(1) = $1000, E(2) = $1,100. MOST PPL PICK 2. BUT if frame as 33% chance to WIN, and then payoff 1: 100% chance of $3,000 or payoff 2: 60% chance of $5,500. (HAVE TO PICK BEFORE YOU KNOW YOU WIN) SAME Expected value, but most ppl pick 1 because of framing.

Prospect Theory:

Evaluation phase formula (not used for calcs)

utility = w(p1) v(X1) + w(p2) v(X2)
w = weightings; v(X1) = value if outcome 1 occurs. p1 = probability of X1 occurring.
-w = tendency of individuals to overreact to small probabilities and underreact to large ones
-value function based on CHANGEs and not level of value.
-S-shaped – loss aversion – when presented with gains BUT most individuals are risk seeking when presented with losses (i.e. sure loss of $75 vs. 50/50 or winning $30 or losing $200).
Efficient Market Hypothesis – types?
Weak form – current prices reflect all past price and volume data. Cannot use technical analysis to generate excess returns. Most studied and supported (historical stock return data appears random) BUT doesn’t mean that historical prices = intrinsic value.

Semi strong form – current prices reflect all public information, including past price and volume data. Cannot use fundamental OR technical analysis to generate excess returns. Studies mostly focus on events or alpha return of investment managers.

Strong form — Includes non-public info. cannot gain excess returns period.

Behavioral Finance challenges to TF
4 alternate models?
1. Consumption and savings model — TF assumes investors are able to save and invest in the earlier stages of life to fund later retirement. This model proposes behavioral life cycle model — lack of self control — if investors frame wealth as current income. Also a framing bias — if investors see bonus as current income, less likely to save it.

2. Behavioral asset pricing — sentiment premium to CAPM — estimated based on dispersion of analysts’ forecasts. If the error of mispricing is systematic and predictable, then can be exploited, if not then no.

3. Behavioral portfolio theory. LAYERS rather than 1 market portfolio
– Each layer = diff return and risk. Allocation based on goals for that layers
– Number of assets in each layer reflect aversion.
– If believes that holds information advantage — more concentrated.
-Flaw is that the risk / return objectives are not compared to each other.

4. Adaptive markets hypothesis (AMH) — Goal is satisfice. Market participants make decisions, evaluate and then evolve by trial and error heuristics to become better. This adapts to the marketplace as a whole. 5 conclusions:
– Risk / Return not stable — changing
– Active management can exploit arbitrage.
– No strategy works all the time.
– Adaptation and innovation are essential to success.
– Survivors change and adapt.

Cognitive errors and emotional biases. Difference?
– CE — due to faulty reasoning, memory errors, and not understanding proper statistical techniques. (Correct by better training or information)
– EB — impulses or intuition — not conscious (thus difficult to overcome).
Cognitive errors:

5 belief perseverances?

4 processing errors?

1. Conservatism bias – when market participants rationally form an initial view but then fail to change that view as new information becomes available.
2. Confirmation bias – market participants look for / distort new information to support an existing view.
3. Representativeness bias – New information based on past classification / experience / rules of thumb without thoughrough analysis (i.e. stock was growth stock before, still is)
— base rate neglect – new info given too much importance (i.e. value stock based on past criteria, evaluate compare to current value stocks
— sample size neglect – (growth stock has low EPS quarter, then reevaluated as value)
4. Illusion of control bias – think you can control or affect outcomes. Fail to diversify / trade excessively
5. Hindsight bias — selective memory of past events / actions (overestimate correctly picked — overly critical of others)

1. Anchoring / adjustment bias — using trial and error, change made in relation to initial view
2. Mental accounting bias — money is treated differently depending on how it is categorized (bonus vs. wages) (also — structuring in layers and failing to account for others / segregating returns into income / realized gains etc)
3. Framing bias — decisions are affected by the way in which the questions / data is framed. (i.e. market value = 20, and cost basis 15 vs. 25).
4. Availability bias — undue emphasis on information available:
a) retrievability – first thought of,
b) categorization,
c) narrow range of experience,
d) resonance.

6 emotional biases?
1. Loss aversion (already covered — myopic loss aversion = shorter term risk of stocks incorrectly leads to excessively high ERP in the market).
2. Overconfidence bias — overestimate abilities or reasoning.
— illusion of knowledge — better job predicting than reality
— self-attribution bias — self-enhancing — personal credit when right, self-protecting — blame others when wrong
—–PREDICTION OVERCONFIDENCE – underestimate uncertainty / st. dev. —-CERTAINTY OVERCONFIDENCE – overstate prob they will be right.
3. Self-control bias – immediate gratification over long term
4. Status quo bias – comfort in existing position. Maintaining it OUT OF INERTIA
5. Endowment bias – asset felt to be special / value bc it is already owned (common in inherited assets).
6. Regret-aversion bias — do nothing out of excess hear that actions could be wrong. (includes herding behavior bc they are not to blame if crowd is wrong too).
Goals based investing (GBI)?

Behaviorally Modified Asset Allocation?

Similar to layers in behavioral portfolio theory (BPT). This explained layers as reflecting whether higher return or lower risk was important to the goal. GBI – starts with importance of ACHIEVING the goal.

Relative importance of goals established:
1. Essential needs . obligations — i.e. bills / living expenses
2. Desired outcomes — i.e. annual giving to charity which can be met with a layer of moderate risk investments.
3. Aspirations – i.e. increase value of portfolio to give away one day — higher risk investments.

Better to adapt or moderate the clients biases to avoid fire sales.
— Consider optimal TF asset allocation,
— Then considers relative wealth of client (high wealth vs. low S of L needs would be low S of L risk — i.e. rich can be eccentric)
— Then considers relative biases. Cog — easier to modify. Emotional — hard to modify have to be adapted to. RW IS IMPORTANT (i.e. low RW, then even if emotional biases, have to modify bc can’t afford to be eccentric).

Classifying investors into personality types:

1. Barnewall two way model

2. BBK five way model

1. Two types of investors — active (risk own capital / more involved) and passive (long steady employment / inheritance — more risk adverse)…

2. Classifies among 2 dimensions. 1, confidence (confident to anxious) and 2, method of action (careful to impetuous).

*Individualist* —Confident —–*Adventurer*
Careful —— *Straight Arrow* — Impetuous
*Guardian* ——– Anxious ——-*Celebrity*

Ind — Make own decisions after analysis. Good to work
Adven — Willing to take chances, unwilling to listen
Guardian — Concerned w future / protecting assets
Celebrity — Seeks / takes advice.

Classifying investors into personality types:

3. Pompian behavioral model

Limitations on Classifying Investors into Behavioral Types?

3. Advisor go through 4 step process:

1. Active or passive (i.e. risk tolerance)
2. Investment style
3. Behavioral biases
4. Plot the results.

Behavioral Investor Types (BITs)
Passive Preserver – Low, Conservative, Emotional
Friendly Follower – Mid-Low, Mid-Conservative, Cognitive
Indep. Individualist – Mid-High, Mid-Aggressive, Cognit.
Active Accumulant – High, Aggressive, Emotional

Most common emotional biases:
– PP = Endowment, loss aversion, status quo, regret aversion
– FF = Regret aversion
– II = Overconfidence, self-attribution
– AA = Overconfidence, self-control

Most common emotional biases:
– PP = Mental accounting, anchoring & adjustment
– FF = Availability, hindsight, framing
– II = Conservatism, availability, confirmation, representativeness
– AA = Illusion of control

– Many Investors exhibit both cog/emotional biases
– Individuals can display more than one type
– As investors age, behavioral changes — decrease risk tolerance and more emotional about investing.
– No two investors the same.

Client Advisor Relationships

Success measured in 4 ways?

1. Advisor understands the long term *goals* of the client.
2. Advisor maintains *consistent* approach
3. Advisor acts as the client *expects*
4. Client and advisor *benefit* from the relationship (primary benefit of incorprating BF into C/A relationship is closer bond bw the two)
Behavioral factors in portfolio construction?

1. Status quo bias?
2. Naive diversification?
3. Excessive concentration in company stock?
4. Home bias?

1. Whatever the default is investors will put in, even as they age. (counteracted by target date funds).
2. 50 / 50 allocation between WHATEVER IS OFFERED. Conditional naive.. — allocate equally bw chosen funds. (avoid regret if you miss high performer).
3. Very risky considering compensation comes from the source of main investment. Framing and status quo bias — if matching made in company stock. Naive extrapolation of past results. Loyalty effect.
4. Failing to invest outside of country.
3 primary behavioral biases that can affect analyst’s forecasts?
1. Overconfidence —
3 ways to mitigate — 1. Self calibration (more accurately recall how close forecasts were in relation to results). 2. Seek at least 1 counterargument. 3. Get feedback by mentors / colleagues.

2. The way management presents information —
3 cognitive biases seen frequently. 1. Framing (typically management might present success first). 2. Anchoring (previous forecasts). 3. Availability (if mgmt gives good info in a memorable way — might be more available).

3. Biased research —
2 biases seen — 1. Confirmation bias (look for good information to support forecast). 2. Gambler’s fallacy (reversal to long term mean more often than happens).

Investment Committee / group decision making:

Biases amplified:
Social Proof bias?

Person follows the beliefs of the group. No feedback typically bc it is inaccurate and slow / many ppl involved.

Committees have the following features:
– Diverse background of individuals.
– Members who aren’t afraid to express themselves / differ in opinion.
– Mutual respect for all.

Behavioral biases of investors — market characteristics:

1. Momentum effect?
2. Bubbles / Crashes — self explanatory
3. Value vs. Growth

1. Correlation in positive returns by herding with other investors (regardless of the info they have). Related to availability bias (RECENT INFO vs. full pic) and fear of regret (don’t want to lose out — can lead to trend chasining effect which causes excessive trading).

3. Farma / French — Value – low P/E, high B/M, low P / Div. better than growth (opposite). BEHAVIORAL HYPOTHESIS — halo effect — growth stocks have good recent performance, therefore buy and therefore misplaced.

Understanding client and needs (profiling):

Situational profiling?

Determining the client’s source of wealth, measure of perceived wealth vs. need and stage of life.

SOURCE OF WEALTH — Active — entrepreneur obviously healthy appetite for risk, but be careful not to assume too much and to confirm. Passive — obviously lower tolerance (inherent or slow steady employment etc).

*Foundation phase* — individuals seeking to accumulate wealth, long term horizon can allow considerable risk taking. (little ability to take risk due to low wealth sometimes unless inheritance).
*Accumulation phase* — earnings / business rise — financial assets can be accumulated (demands might also rise i.e. kids / house).
*Maintenance phase* — often means retirement. living off the portfolio – lower risk tolerance but not too conservative to keep pace of living.
*Distribution phase* — Assets exceed levels of need and distributing can begin. (For wealthy time horizon could extend beyond death and risk tolerance could be high).



Benefits for the client? Advisor?

IPS will include the financial objectives (O) and constraints (C).

Client: – identifies and documents O&C.
– dynamic — change according to client or market conditions.
– easily understood, can use others without interruption.
– education experience.

Advisor: – Greater knowledge of client
– Guidance for decisions
– Guidance for conflict resolution (used to support decision and denial’s of client’s requests).

IPS: Objectives?
Typically risk and return. However have to be consistent with reasonable market expectations and client’s constraints.

Often can be divided into required and desired. Required = high priority / critical goals. Do not distinguish bw income and growth sources (CFA takes total return approach).

Ability and Willingness
Ability affected significantly by expenditures & critical goals relative to the portfolio / time horizon / whether portfolio is sole source of support.
Willingness affected by psychology. Parse out conflicting info (i.e. I’m an average risk — invests in super risky individually). Usually go with more conservative.

IPS: Constraints?
1. Time Horizon. Long = 15 yrs / short = <=3 yrs. Many investors have multistage time horizons -- i.e. 10 yrs to retirements and retirement of 20-25 yrs. NOTES: -- state stages, main obj of stages, # of years in stage. -- Look for stages beyond individual -- i.e. future inheritance from someone. And also multi-generational - passing on wealth 2. Taxes. Deferral, Avoidance, Reduction, Transfer tax avoidance. 3. Liquidity. Ability to meet anticipated and unanticipated cash needs. Function of transaction costs to liquidate and price volatility. NOTES: -- Emergency cash reserves unusually not required unless stated. Note illiquid assets here. 4. Legal / Regulatory factors -- Most common to individuals are personal trusts (revocable -- retain ownership -- still taxed on them / irrevocable -- pass to trustee to pay taxes on it -- considered a transfer for wealth tax) and foundations. 5. Unique circumstances. -Socially responsible investing. -Special instructions (i.e. gradually liquidating) -Restrictions on the sale of assets (large holding of stock) -Restrictions from client -Assets outside portfolio (residences) -Bequests.
Strategic Asset Allocation considerations:

Average risk investor?
Don’t ignore?

– Excessive cash drag
– Don’t meet liquidity requirements / delineated constraints.

-Rule of thumb is 60/40 equity / appreciation to bond / income producing.

-Home ownership!

Compare traditional approach to retirement planning + Monte Carlo approaches:

Both start with?


-Time horizon to retirement and length of retirement.
-Investors’ income and savings, assets, & tax status.
– Interest rate, asset returns, etc assumptions.

Traditional — calculates a single constant return
Monte Carolo — each VARIABLE is given a probability distribution to allow for real world uncertainty. Repeated for 10,000+ path outcomes.

– Considers path dependency (i.e. if the market tanks — it would have an impact on liquidity needs that would come at a low point, so even if market recovers — then you have withdrawn MORE at a low point)
— More complicated tax analysis can be considered. (i.e. tax burden from tax deferred accounts during a market downturn).
–Clearer understanding of short-term / long term risk can be gained (i.e. holding less risky assets reduces variability / but also increases risk of not having enough assets in the future).
–Better at assessing multi-period effects.

–Using historical data for inputs.
–Using assets classes to simulate returns — not assets themselves. (i.e. have to pay fees).
— Simplistic tax modeling.

Investor questionaries?

Investor types (non-Pompian)

Typically focus on non-investment type of questions to understand personality types / psychology.

Cautious — risk adverse — long time to make decisions — often invest in safest securities
Methodical — long time researching, but confident making decision — somewhat conservative
Spontaneous — little attention to valuation issues — ‘hot investment idea — high turnover / volatility
Individualistic — like methodical, but less risk adverse.

7 types of tax regimes
Common Progressive (Favorable for all).
Heavy Interest / Div / Cap Gain Tax
Light Cap Gain Tax
Flat and Light (like Common, but flat tax)
Flat and Heavy (Favorable only for interest income)
Accrual tax?
Ex: 1000 invested for 20 yrs. before tax return of 10%. ACCRUAL tax rate of 30%. Calc after tax value in 20 yrs?
Tax drag?

3 Fundamental relationships w accrual taxes?

Tax paid annually!

Ex: 1000 (1+ 0.10 (1-.3))^20
= 3,869.68

Tax drag = gain lost to taxes
1000 (1+.10)^20
=6,727.50 = value w/o taxes
=6,727.5 – 2,869.68 – 1,000 = 2,857.82 = tax drag $
2,857.82 / 5,727.5 = tax drag %

1. Compounding of accrual taxes makes their effect (in %) — greater than the actual tax rate == i.e. tax drag > tax rate.
2. Increasing the investment horizon increases tax drag in $ and %.
3. Increasing the return on investment increases tax drag (in $ and %).

Deferred Capital Gains tax?

Ex: 1000 invested for 20 yrs. before tax return of 10%. DEF tax rate of 30% at year 20. Calc after tax value in 20 yrs?

What does this demonstrate?

What if a different cost basis?

FVIFcgt = (1+R)^N (1-Tcg) + T cg

1000 ((((1+.10)^20)*(1-.3))+.3)
=4,709.25 + 300 = 5,009.25
(Last part is bc the original investment isn’t subject to cap gains tax — i.e. only the GAIN)

Loss to deferred taxes (i.e. tax drag) is a constant rate regardless of the investment horizon. Therefore — over time and with higher returns you gain more $$ bc remember w accrual taxes there was an increasing % of tax drag.

Would change formula slightly to affect last term:
FVIFcgt = (1+R)^N (1-Tcg) + Tcg (*B*)
B = percentage of account value
i.e. if the cost basis in the prior example was $750 of $1,000, B = 0.75.

Wealth based tax rate?

Ex: 1000 invested for 20 yrs. before tax return of 10%. WEALTH tax rate of 2% for 20 years. Calc after tax value in 20 yrs?

Similarity / difference bw accrual and wealth tax?

Applied to principal and returns annually. (Typically lower than income based).

FVIFwt = ((1+R)(1-Tw))^n

Ex: 1,000 ((1+0.10)(1-.02))^20 = 4,491.33 = after tax
1,000 (1+0.10)^20 = 6,727 = before tax.

Similarity = As with accrual taxes — tax drag $ and % INCREASE with investment horizon.
– tax drag % > tax rate

Difference = Unlike accrual taxes when investment return increases — tax drag % DECREASES. ($ still goes up)

After realized tax return

Ex: Account was 100,000, now 110,000. Everything reinvested.
Interest = 300; t = 30%
Divs = 4,000; t = 20%
RCG = 2,200; t = 20%

But have to consider deferred capital gains too.
Effective capital gains rate?
Ex: Same assumptions as above. Cost basis = 75,000. Return proportions equal for 8 yrs.
Calc the effective CG rate and the balance of the account in 8 yrs after payment of all taxes.

If we want the effective annual return with all these considerations?
-*Accrual equivalent after tax return*?
-Difference bw accrual equivalent after tax return and pre-tax return?
-Accrual equivalent tax rate?
—- Assuming entire return is in deferred cap gains:
——–What happens to Tae as the Basis (B) increases?
——– What happens to Tae as the time horizon increases?

Rart =R (1 – realized tax rate)
Rart = R (1 – (PiTi+PdTd+PcgTcg))
P = proprtion of TOTAL return (including unrealized cg)

Ex: realized tax rate = 300(.3)+4000(.2)+2200(.2) = .133
Rart = 8.67%

Tecg = Tcg ( (1-(Pi+Pd+Pcg))/(1-(PiTi+PdTd+PcgTcg)) )
FVIFt = [(1+Rart)^n (1-Tecg) + Tecg – (1-B)Tcg]

Ex: Tecg = .2 ((.35) / .867) = *.0807*
FVIF = [(1+.0867)^8 (1-.0807) + .0807 – (1 -.75).2]
= 1.8185 *100,000 = *181,855. *

FV = PV (1+Rae) ^ n)
Rae = [(FVt / PV) ^ (1/n) ] – 1
(basically the geometric mean return for the N periods)

tax drag.

Tae = 1 – (Rae / R)
—- It goes down bc less and less of principal taxed.
—- It goes down bc longer that tax is deferred.

Tax deferred account? Formula?
Tax exempt account? Formula?

What if the contribution limits are the same?

Like IRA. FRONT-end loaded tax benefits
Same as CG when basis = 0.
(1+R)^N (1-Tn)
Tn = Tax rate at time of withdrawal

Like Roth IRA. BACK-end loaded tax benefits.
No issue w taxes == (1+R)^N
BUT because using after tax dollars — you have to pay (1-T₀) on your initial investment.
(1+R)^N (1-T₀)

NOTE: IF T₀ = Tn then it doesn’t matter!

TEA provides the better benefit (to make TEA and TDA equivalent have to invest x / (1 – T₀) in TDA vs. x in a TEA).

How do taxes affect investment risk?

i.e. half equity (σ = 16%, T = 20%) / half bonds (σ = 6%, T = 30%). What is the pre and after tax portfolio st deviation?

Part of the investment variability is absorbed by the gov’t. On a pre-tax basis if the st deviation is σ, and investment returns taxed as income, an investor’s after tax risk is σ (1-T). DOESN’T HOLD for Tax deferred / exempt accounts.

Pre tax = .5 (.16) + .5 (.06) = .11
After tax = .5 (.16) (.8) + .5 (.06) (.7) = .085

**NOTE — this means ALL ELSE EQUAL, TAXABLE accounts have lower risk than tax deferred / tax exempt accounts.

Tax alpha?

Investor’s trading behavior:
— 4 types of equity investors?

Tax loss harvesting?

HIFO tax accounting?

Tax alpha — 2 points?

** IF PERFORMED CORRECTLY, mean variance optimization would incorporate __________ returns and __________ st. deviations.

The value created by the effective tax management of investments.
(ie ** if calc, TAX SAVINGS by tax loss harvesting, not net tax).

1. Traders — all gains are short term. No tax advantage.
2. Active investors — active investors, but less than traders, so mostly long term.
3. Passive investors — buy and hold — so gains are deferred and taxed at preferential rates.
4. Exempt investors — Avoiding taxation all together (accounts / securities).

Using investment losses to offset gains.

Highest in, first out — large blocks of stock, able to use the highest amount first to use as basis.

1. Volatility is good for tax loss harvesting / tax alpha.
2. Trading can be beneficial in certain circumstances (excessive trading using associated w inefficiencies)

accrual equivalent after tax returns;
after tax standard deviations;


Estate planning?



Financial assets, RE, collections, businesses, and non-tangibles

Process of transferring your estate over the course of your lifetime or at death to those you intend to. Most common way to transfer assets — will. TESTATOR — the person transferring assets through a will.

Legal process that takes place at death. Court determines, validity of the will, inventories the decedents property, resolves any claims, and distributes the property. To have died

‘INTERSTATE’ means leaving no will and distribution of assets according to the court.

2 primary means of transferring assets?

Gifts referred to as:
lifetime gratuitous transfers?
inter vivos transfers?

testamentary gratuitous transfers?

Civil law vs. Common law?

Taxing regimes:
Forced heirship?
Community Property Rights?
Separate Property Rights?

Gifts and bequests.

-w/out intent of receiving anything in return
-bw living individuals.

-after death w/out intent of receiving anything in return

Civil — top down by legislative body
Common — bottom up — judge decisions that refine laws become precedent.

-Children have right to portion of parent’s estate regardless of location / relationships etc. If parents try to forcibly remove assets to another regime — claw back provisions in effect — would add that value back to the estate.
– Each spouse entitled to 1/2 of estate EARNED during the marriage. gifts / inheritances received before / after marriage can be held separately from martial assets.
– Common in civil law countries — each spouse may, barring forced heirship — bequest OWN assets as they wish.
NOTE: WHEN Spouses fall under forced heirship AND community property, they get the GREATER of the 2 rules.

Core capital / Excess Capital?

Mortality probabilities?

Longevity risk / Probability of ruin?

Addition rule — probability?

For an individual, total assets = held assets and PV of future assets gained through employment (i.e. HUMAN CAPITAL or NET EMPLOYMENT CAPITAL). Total liabilities = discrete liabilities and future costs to maintain lifestyle (cost of living / planned gifts etc).

EXCESS CAPITAL is Total assets less liabilities above.
CORE CAPITAL is the Total assets needed to meet your liabilities (plus minor reserve for unexpected needs).

Obvious tough to forecast future income / liabilities. But also tough to forecast LIFETIME!

Prob of running out of assets before death.

P(A or B) = P(A) + P(B) – P(AB)

Excess capital and gifting now vs. bequesting:


What are the formulas for:
Tax free gift?
Gift taxable — paid by receiver?
Gift taxable — paid by giver?

FV after tax to receiver if gifted now / FV after tax to the receiver if bequested at death.

> 1 — favorable to gift now
< 1 -- favorable to gift later. g= gift receiver / e = donor Te = estate tax / Tg = gift tax) [1 + rg (1 - tig) ] ^ n / [1 + re (1 - tie) ] ^ n * (1 - Te) [1 + rg (1 - tig) ] ^ n * (1 - Tg) / [1 + re (1 - tie) ] ^ n * (1 - Te) [1 + rg (1 - tig) ] ^ n * (1 - Tg + TgTe) / [1 + re (1 - tie) ] ^ n * (1 - Te) **** Last term here to account for the fact that giver's estate is reduced and the future estate tax will be lower.

Generation skipping estate planning?

What is the formula that shows the value of generation skipping relative value?

Spousal exemptions?

Valuation Discounts?

Charitable Gratuitous transfers?

When transfer assets to 3rd generation, avoid having to tax the transfer to 2nd generation, then tax on 2nd generation to 3rd generation.

1 / (1-t)

Estate can pass to spouse tax free. *** IMPORTANT bc if there is a $1 mill limit that lets you transfer estates tax free, and you had $3mm estate. You could bequeath $1 mm to kids, $2mm to spouse and be tax free. Then spouse could bequeath the rest.

Valuing private businesses is hard and can apply liberal DLOCs and DLOMs depending on the size of the business.

Relative value almost always higher for gifting now:
[1 + rg] ^ n + (To * (1+re(1 – tie)) ^ n * (1 – Te)) /
[1 + re (1 – tie) ] ^ n * (1 – Te)

NOTE: – 1+rg is untaxed bc charity
– get a tax break now which is compounded over time * the estate tax rate at death to be given to charity.


Asset ownership:
-Revocable trust?
-Irrevocable trust?

-Fixed trust?
-Discretionary trust?
-Spendthrift trust?

Trusts most common in?

Means by which a grantor (settlor) can transfer assets to beneficiaries outside of the probate process. TRUSTEE (manager of the trust) holds the assets and managers them in the best interests of the beneficiaries according to the constraints of the trust documents.

-Because settlor can revoke to retain ownership of assets, still considered legal owner for tax and legal purposes (open to creditors, divorcing spouses etc.)

-Trustee ownership for tax purposes — responsible for paying etc. Protects from claims against creditors, unless created in anticipation of a claim.

Settlor determines pattern of distributions.

Trustee determines how assets to be distributed; primary concern is that the assets are distributed to produce the greatest benefit. Settlor can convey wishes through trust documentation or letter of wishes. TRUST ASSETS ARE PROTECTED AGAINST CLAIMS FROM BENEFICIARIES.

– Meant to transfer assets to beneficiary who is too young to manage assets.

– Common law countries (foundations more common in civil law countries);

Life insurance and estate planning?

Source jurisdiction vs. residence jurisdiction?

Exit taxes?

Can be very efficient tax wise. Only asset transferred in premiums paid; in most jurisdictions, life insurance proceeds pass to beneficiaries without tax consequences, and in many cases can accumulate wealth tax free;

Income tax:
Source — (i.e. territorial tax system); country levies taxes on all income by citizens / foreigners in its border;
Residence — all citizens income taxed regardless residing inside or outside of the country; all residents pay income taxes as well (subjective — family or house / objective — # of days in country — standards);

Wealth taxes:
Source: — country levies taxes on assets LOCATED or TRANSFERRED within;
Residence: — citizens / residents pay transfer taxes on all assets, regardless of location;

Some people renounce citizenship to avoid taxes:
– Exit tax — usually based on gains of assets leaving (as if they sold it) — known as DEEMED DISPOSITION; could also include tax on income earned for period after expatriation (SHADOW PERIOD);

Double taxation from residence / source issues:

Residence / Residence?
Source / Source?
Residence / Source?
— Alleviation of this last issue?

– Two countries claim you
– Two countries claim authority over the same income stream
– Income in a source country, resident of a residence country;

—Credit method – Residence country allows tax credit for taxes paid in source country. Tax rate is the greater of source or residence country;
—Exemption method — residence country exempts income from a country that enforces source jurisdiction;
— Deduction method — partial relief; only get to deduct taxes paid from worldwide income.

Tax avoidance vs. evasion?

Individual Taxation usually happens on _____ levels?

Avoidance is legal — Minimize taxes based on existing laws;

Evasion is illegal — misrepresenting / hiding; ultimately caught due to increasing transparency and information sharing of countries and banks;

4 levels: Tax on: income, spending, wealth, and assets when transferred.

Concentrated Single Asset Positions:

Risk in assets is both __________

3 common objectives when managing a concentrated position?

Other considerations not to reduce the position?

Capital market and institutional constraints on investor’s ability to reduce a concentrated position?

Systematic risk: Cannot be diversified away / market risk;

Company specific risk: Events that affect a specific investment but not the overall market; (Property specific risk — counterpart for RE risk)

1. Reduce the risk caused by concentration
2. Generate liquidity to meet diversification / spending needs
3. Optimize tax efficiency

– Restrictions on sale (i.e. company executive)
– Desire for control (majority ownership)
– To create wealth (i.e. entrepreneurship)
– Asset may have other uses (RE owned is used by client or client’s businesses);

-Margin lending rules — limits % of asset value that can be borrowed.
-Securities law — “Insiders”
-Contractual restrictions – minimum holding periods / blackout dates
-Capital Market limitations – dealers not able to short stock, illiquid market of IPO

Concentrated Single Asset Positions:

Goal based decision making process?

Asset location?

Asset location / wealth transfer in managing concentrated positions:
-Advisors have the greatest impact when there are no ?
– Explain estate tax freeze?

Modifies the traditional mean-variance anaylsis to accommodate behavioral finance.
Risk buckets:
– Personal risk bucket – protects client from poverty (MM or CDs & personal home)
– Market risk bucket — Maintain the client’s standard of living (stocks / bonds)
– Aspirational risk bucket — Could substantially improve client’s standard of living (concentrated risk / RE / private business).
PRIMARY CAPITAL — meets goal of first 2
SURPLUS CAPITAL — Aspirational goals. IF THIS ISN’T ENOUGH TO MEET PRIMARY CAPITAL, need to sell this off.

– Determines the method of taxation that will apply.

– Unrealized gains
– Way to transfer future tax appreciation / liability to a future generation. i.e. guys wants to to transfer future price appreciation of business to son w/out paying immediate tax. $30mm company w 0 basis. FREEZE — transfer stock ownership into voting preferred ($30mm) / common ($0mm). Keep preferred and transfer common to heirs. No tax due until the preferred is transferred.

3 broad techniques to manage concentrated positions.

Ex: own 100,000 shares of PBL stock at $50. What are some potential monetization tools?

Ways to lower cost of protective puts?

1. Sell asset
2. Monetize the asset
3. Hedge the asset. (OTC — CP risk and Specific — or Exchange traded — standard, transparent, pricing available)

Receiving cash for position without triggering tax.
1. Hedge position (without triggering liability as a de facto sale)
2. Borrow using the hedged position as collateral.

1. Short sale against the box. — Short 100,000 of PBL and use the proceeds (only owe rfr to borrow funds)
2. Equity forward sale — contract the sell 100,000 for XX price.
3. Forward conversion w options. selling calls and buying puts.
4. Total return equity swap. total return of PBL for LIBOR.

– Purchase out of the money
– Shorter time to expiration
– Pair of puts, buy high, sell low (give a band of protection).
– Non standard features — KNOCKOUT PUT — expires prior to expiration if stock price rises above certain level.
-Zero premium collars (find indifference point where puts and calls = same amount).
– PREPAID VARIABLE FORWARD — collar and loan in one transaction. Dealer pays owner $45 / share of the PBL shares. To repay, the investor has to deliver shares on a future date with terms: i.e. all shares if $50 or under, reduction in shares if over $50.

Tax considerations of hedging strategies?

Two tax optimization strategies?

Perfect Hedge?
Cross hedge?

Exchange Funds?

-Mismatch in character — different tax rates for different tax characteristics (cap gain vs ordinary income).
-Yield enhancement with covered calls

-Index tracking w active management (take cash from monetized position. is cap gains vs divs lower taxed? chose the low taxed item as the more focused strategy)
-Completeness portfolio (whatever concentrated position is — get diversification portfolio that has low correlation w concentrated asset)

Generally inappropriate (doesn’t exist or triggers tax)

Accomplished 3 ways (assume large auto stock position)
1. short shares of another auto stock HIGHLY correlated w underlying.
2. short index highly correlated w the stock. STILL introduces company specific risk.
3. Purchasing puts (different types of assets so technically a cross hedge)

Different investors contribute assets to 1 exchange fund in exchange for a % of ownership — gives diversification w/out triggering taxable event.

Strategies for managing a private business position include?
1. Strategic buyers generally offer best price to seller.
2. Financial buyer – lower price (plan to restructure /add value / and resale); more mature;
3. Recapitalization — middle market; Leveraged recap — PE firm arranges the financing for the company to purchase owner’s stock. (usually get equity in exchange for this). Can be part of a phased exit strategy — i.e. taxed now on recap, sell rest when PE firm exists later.
4. Sale to management / key employees. Buyers need a discount and promissory note (to seller) to make the deal happen; promissory note contingent on future performance (MBO); damaging negotiations w ppl tasked w running business;
5. Selling non-core assets;
6. Gift / sale to family members
7. Personal LOC secured by company shares.
8. IPO
Strategies for managing a concentrated RE position include?
1. Mortgage financing – Nonrecourse loan — lenders only option is to seize the building (effectively a ‘put’ option on RE, if the property value falls below the proceeds received can just stop payment). INCOME producing property could have 0 CF impact on borrower (income pays interest needed)
2. Donor advised fun / charitable trust — Can have low tax basis after sign gains / depreciation over the years. If donated to a charity — can take large tax deduction and the charity can sell tax free.
3. Sale leaseback — selling property and immediately having the contracted lease. i.e. sell property 100% FMV, 10-20 year lease. NOTE: NOW rent is tax deductible expense.
Human Capital?
FInancial Capital?
Total wealth?

Why might HC not be 0 at retirement?

HC = PV of individuals projected future earnings; Generally 0 at retirement; Subject to earnings risk that you can reduce by building more FC quicker; Life insurance can cover loss of HC with FC;

FC = current market value of individual’s portfolio assets; Face longevity risk of outliving FC in retirement (can counteract w annuities); Historically SS and pensions were larger portion of income at retirement, but now not so hence the more longevity risk;

Total wealth = HC + FC; make sure to consider life insurance and annuities;

HC is considered a portfolio asset; FUTURE RECEIPTS FROM SS OR DEFINED BENEFIT (DC would be financial capital bc you can control it); makes the retirement HC > 0;

When HC considered — the optimal mix of financial assets must consider?

Life insurance and Human Capital?
Life insurance and Financial Capital?

-If HC is more like equity (volatile), then more allocation to fixed income appropriate.
-If HC is more like fixed income (steady), then more allocation to equity appropriate.
*** Should consider its correlation to other assets are size. Treat like asset class.

If HC fixed income like. Then lower discount rate, higher PV and larger demand for life insurance.
If HC equity-like. Then higher discount rate, lower PV and lower demand for life insurance.

Higher risk aversion, less aggressive financial portfolio, more demand for life insurance
Lower risk aversion, more aggressive financial portfolio, less demand for life insurance;

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