Life stages are a progression and the normal progression is as follows:

– Foundation phase when individuals are seeking to accumulate wealth through a job and savings, seeking education, or building a business.
– Accumulation phase when earnings or business success rise and financial assets can be accumulated.
– Maintenance phase, which often means retirement.
– The distribution stage means assets exceed any reasonable level of need for the individual and a process of distributing assets to others can begin.

Traditional finance (i.e., modern portfolio theory) assumes investors exhibit three characteristics:

– Risk aversion. Investors minimize risk for a given level of return or maximize return for a given level of risk and measure risk as volatility.
– Rational expectations. Investors’ forecasts are unbiased and accurately reflect all relevant information pertaining to asset valuation.
– Asset integration. Investors consider the correlation of a potential investment with their existing portfolios. They focus on the impact of adding a new asset on the return and risk of the total portfolio.

Four very general categories of attitude and style exist and may provide indications into investment-related behavior. Through this process, investors can be classified as cautious, methodical, individualistic, or spontaneous.

– Cautious investors are risk-averse and base decisions on feelings.
– Methodical investors are risk-averse and base decisions on thinking.
– Individualistic investors are less risk-averse and base decisions on thinking.
– Spontaneous investors are less risk-averse and base decisions on feelings.

The investment policy statement (IPS), in fact the entire process of developing the IPS, is valuable for both the client and the investment adviser. For the client, the benefits of the IPS include:

– The IPS identifies and documents investment objectives and constraints.
– The IPS is dynamic, allowing changes in objectives and/or constraints in response to changing client circumstances or capital market conditions.
– The IPS is easily understood, providing the client with the ability to bring in new managers or change managers without disruption of the investment process.
– Developing the IPS should be an educational experience for the client.

The investment policy statement (IPS), in fact the entire process of developing the IPS, is valuable for both the client and the investment adviser. For the adviser, the benefits include:

– Greater knowledge of the client.
– Guidance for investment decision making.
– Guidance for resolution of disputes.

Taxation is a global issue and must be taken into account when formulating an investment policy for an individual. Some general classifications of taxes are as follows:

– Income tax.
– Capital gains tax.
– Wealth transfer tax.
– Personal property tax.

The effects of taxes must be considered when determining the investment strategy for any taxable investor.
The following strategies are used to reduce the adverse impact of taxes:

– Tax deferral.
– Tax avoidance.
– Tax reduction.
– Wealth transfer taxes.

There are three primary categories of taxes:

– Taxes on income.
– Wealth-based taxes.
– Taxes on consumption.

For capital gains taxes, it can be generalized that:

– Unlike accrual taxation, there is no lost compounding of return due to paying taxes periodically. All tax is paid at the end of the time horizon.
– The tax drag amount will increase as the time horizon and/or rate of return increase because the tax will be on a larger pretax ending value.
– The relationship of the tax drag percentage and stated tax rate will depend on the basis (B) if there is no initial unrealized gain or loss and B equals 1.00, the tax drag percentage is equal to the tax rate.
– The relationship of the tax drag percentage and stated tax rate will depend on the basis (B) if there is an initial unrealized gain and B is less than 1.00, the tax drag percentage is greater than the tax rate because there is an additional initial gain subject to tax.
– The relationship of the tax drag percentage and stated tax rate will depend on the basis (B) if there is an initial unrealized loss and B is greater than 1.00, the tax drag percentage is less than the tax rate because the portion of the return earned during the period back to the cost basis is untaxed.

Many countries offer accounts that allow funds to be deposited and invested in a tax-advantaged manner. These accounts provide a tax advantage. No taxes are imposed on return while funds are in the account, allowing pretax compounding of returns. These accounts can generally be classified as:

– Tax-deferred accounts (TDA): Pretax funds are deposited. The investor can take a tax deduction for the amount contributed, reducing taxable income and taxes due. All tax is deferred until withdrawal, allowing tax-deferred compounding. Because no tax was paid on the funds deposited, tax is due on the full amount of withdrawals.
– Tax-exempt accounts (TEA): Because after-tax funds are deposited, no tax is due on the returns earned or on withdrawals. Therefore, the after-tax future value does not explicitly depend on tax rate.

Generally, the more frequent the trading, the less the ability to defer taxes, increasing tax drag and decreasing after-tax return. Trading behavior can be differentiated as:

– Traders—due to frequent trading, all gains are realized frequently and taxed at a generally higher rate with no deferred tax compounding. Tax alpha is lost.
– Active investors—trade less frequently than traders so that many of their gains are longer-term and taxed at lower rates.
– Passive investors—buy and hold equity so that gains are deferred to benefit from pretax compounding and are taxed at lower long-term rates.
– Exempt investors—avoid taxation altogether.

Tax-loss harvesting refers to realizing losses to offset realized gains or other taxable income. It reduces the taxes due now but generally does not reduce eventual total taxes. If the benefit is taken now to lower taxes now, it cannot be used in the future and taxes in the future will be higher. Even so, tax-loss harvesting is beneficial.

The implications of a higher short-term versus lower long-term gains tax rate are:

– The ratios of ending after-tax value of the patient and rapid trader increase in favor of the patient trader at higher rates of return.
– The ratios of ending after-tax value of the patient and rapid trader increase in favor of the patient trader over longer investment horizons.
– Rapid trading would require a much higher pretax return to break even on an after-tax basis.

Tax-exempt account (TEA) contributions provide a back-end tax advantage; contributions are after-tax, and withdrawals are not taxed:

– If the current and the expected future tax rate are equal, TDA and TEA provide equal future value.
– If the future tax rate is expected to be lower, use the TDA.
– If the future tax rate is expected to be higher, use the TEA.

The two primary means of transferring assets are through gifts and bequests.

The trustee (i.e., manager of the trust) holds the assets and manages them in the best interests of the beneficiaries according to the following constraints of the trust documents.

– In a revocable trust, the settlor can rescind (i.e., revoke) the trust and resume ownership of the assets. The settlor is considered the legal owner of the assets for tax and reporting purposes, and creditors, divorcing spouses, et cetera can make claims against the trust assets.
– In an irrevocable trust, the settlor relinquishes ownership and control. The trustee is considered the owner of the assets for tax purposes and is responsible for reporting and paying taxes on income generated by the trust. The irrevocable trust protects the trust assets from claims against the settlor.

Concentrated positions can have consequences for return and risk. The major types of risks include:

– Systematic risk.
– Company-specific risk.
– Property-specific risk.

There are three common objectives when managing a concentrated position:

– Reduce the risk caused by the wealth concentration.
– Generate liquidity to meet diversification or spending needs.
– Optimize tax efficiency to maximize the after-tax ending value.

Institutional and capital market constraints such as tax law (covered previously) can significantly affect the costs of selling or monetizing a concentrated position. Legal issues can depend on the form of asset ownership: sole proprietorship, limited partnership, limited company, or public stock.

A five-step process can be used to make decisions for managing a concentrated position:

– Establish written objectives and constraints for the client. Nonfinancial issues such as retaining control of the asset and wealth transfer goals should be included in the document.
– Identify the techniques and strategies that best meet these objectives and constraints.
– Consider the tax advantages and disadvantages of each technique.
– Consider the other advantages and disadvantages of each technique.
– Document the decisions made.

Three broad techniques can be used to manage concentrated positions:

– Sell the asset: This will trigger a tax liability and loss of control.
– Monetize the asset: Borrow against its value and use the loan proceeds to accomplish client objectives.
– Hedge the asset value: Often done using derivatives to limit downside risk.

The following are several ways to lower the cost of the protection:

– Purchase an out-of-the-money put as just described.
– Buy a put with a shorter time to expiration.
– Use a pair of puts, buying a put with a higher strike price of XH and selling a put with a lower strike price of XL.
– Add exotic features to the option (not found in standard options).
– No-cost or zero-premium collars are a common way to lower initial cost, in this case to zero, by giving up some stock upside.

Exit strategies for the business must be considered. Exit strategies include monetization, sale, a phased sale over time, or an adjustment to the business structure that will provide the owner with cash. Exit strategy analysis should consider:

– The value of the business.
– Tax rates that would apply to the potential exit strategies.
– Availability and terms of credit, as borrowing may be involved in financing any transaction.
– The buying power of potential purchasers.
– Currency values if the transaction involves foreign currencies.

The strategies to consider include:

– Mortgage financing can be an attractive strategy to raise funds without loss of control of the property.
– A donor-advised fund or charitable trust can allow the property owner to take a tax deduction, gift more money to the charity, and influence the use of the donation.
– A sale and leaseback can provide immediate funds while retaining the use of the property.

A goal-based decision process modifies traditional mean-variance analysis to accommodate the insights of behavioral finance theory. The portfolio is divided into tiers of a pyramid, or risk buckets, with each tier or bucket designed to meet progressive levels of client goals in this order:

– Allocate funds to a personal risk bucket to protect the client from poverty or a drastic decline in lifestyle. Low-risk assets such as money market and bank CDs, as well as the personal residence, are held in this bucket. Safety is emphasized, but a below-market return is likely.
– Next, allocate funds to a market risk bucket to maintain the client’s existing standard of living. Portfolio assets in this bucket would be allocated to stocks and bonds earning an expected market return.
– Remaining portfolio funds are allocated to an aspirational risk bucket holding positions such as a private business, concentrated stock holdings, real estate investments, and other riskier positions. If successful, these high-risk investments could substantially improve the client’s standard of living.

The investor who holds a large position in an auto stock but finds it cannot be shorted to create a hedge could consider three cross hedge possibilities:

– Short shares of a different auto stock or another stock that is highly correlated with the concentrated position. The highly correlated short position will increase (decrease) in value to offset decreases (increases) in the auto stock.
– Short an index that is highly correlated with the concentrated position. Shorting a different stock or an index will introduce company-specific risk. A negative event could affect the concentrated position but have no offsetting effect on the value of the short position.
– Purchasing puts on the concentrated position is also considered a cross-hedge in that the put and stock are different types of assets.

The primary purpose of an estate tax freeze is to shift the tax burden from the current owner of an asset.

Variable annuities are more likely to allow cashing out (at the market value with surrender fees). Fixed annuities have a more certain income and generally lower fees but are generally not easily redeemable.

Some of the important policy types and implications for portfolio management include:

– Whole life or ordinary life.
-Term life insurance.
– Variable life, universal life or variable universal life.

The risks included in the life insurance company’s objectives are:

– Valuation risk.
– Reinvestment risk.
– Credit risk.
– Cash flow volatility.