Monday, November 15, 2010

Ground Rules & Constraints: Investment Policy Statement (IPS)…Puttin’ It Together Part III

Ground Rules & Constraints: Investment Policy Statement (IPS)…Puttin’ It Together Part III

(Note: An IPS is not to be confused with IBD – though some say it has the same effect)

Amount (after tax)
Rate of Return (after tax)
Inflation (deflation?) rate?
Time Horizon for Accumulation if applicable
Time Horizon for Distribution (if different than
Frequency (of monitoring)
Rebalance (frequency)
Probability desired (Pessimistic, Optimistic, Realistic)
(no 100%!)

Where At Today:
Amount of Dedicated Resources
Monte Carlo Probability:


Risk Constraints: Present Level – Desired Level (see prior blogs)

· Inflation or Deflation Risk
· Systemic Risk
· Interest Rate Risk –
· Liquidity Risk
· Market Risk Market Timing Risk
· Reinvestment Risk Repayment
· (Credit) Risk Monetary Risk – the value of currency declining
· Political Risk.
· Divorce Risk

· Third, after you retrofit your portfolio per objective what each risk would look like (prone to offset) to make tradeoffs between the requirements of the goal and you concern for the risk –prone/offset ratio.

Retrofitting Constraints by Percentage by Level
(see prior blogs)

· Preservation of nominal capital
· Preservation of purchasing power
· Liquidity
· Restored liquidity (income from an illiquid assets)
· Current taxable income
· Tax sheltered income
· Capital appreciation
· Asset protection (from creditors)
· Tax savings

Level 1 (lowest risk)- _________% criteria:
Level 2 (below average risk) __________%, criteria:
Level 3 (average risk) ___________%, criteria:
Level 4 (above average risk) __________%, criteria
Level 5 (highest risk) ____________% criteria:

Target Percentage Allocation (as a result of the above)

Asset Categories to Avoid:

As is Target Acceptable Range Beta
Fixed Income
Equity Value
Domestic Growth & Inc.
Domestic Growth
Int’l Large
Int’l Medium
Int’l Small
Equity Income
Equity Growth
Overrides (i.e no one stock, mutual fund etc investment to equal more than ____%

Other Factors Impacting & What To Do:

1. Percentage decline willing to accept before triggering sale:

2. Total Disability (are your insured, if not…)

3. Partial Disability (see #2)

4. Long term care (see number 2)

5. Advanced Medical Directive (what should change?)

6. Financial Durable Power of Attorney (who, what changes if in effect?)

7. Other

Potential Problem Analysis

(I suggest dealing with those that have a medium to high probability(P) (1) and medium to high seriousness (S) (2) and attempt to transfer the risk of those via insurance or otherwise that have a low probability (P) and a high seriousness (S) ((i.e. think hurricane, disability, long term care etc.)

Potential Problem P(1) S(2) Cause(s) Prevent Minimize





Whew! – that’s a lot – but it’s the first run. The question is do you want to play – who do your trust – or manage your goals? Most will spend 100,000 hours working making over their lifetime $2million, $5 million, $10million or more and not spend 200 hours keeping it.

Would you invest in a firm that has gross revenues of $10 million but spends less than 200 hours keeping it? What would you think about it’s management?

Again, personal financial life planning (Enough) is about healing financial anxiety – not making you a planner but for you to manage your goals and planner. Otherwise you can just blame, complain, and play the victim (which should come easy to liberals, collectivists, & progressives) --- Your choice.

At the least, this investment policy statement gives you a working paper framework to deal with your advisors

For more – get my book Enough probably available on ebay or used (as it is out of print) for a couple of bucks until – when and I – I do a third edition (which would be titled:

FUability©: Healing Financial Anxiety Puttin’ Money In Its Place- The ENOUGH(sm) Process

Saturday, November 6, 2010

Ground Rules & Constraints Asset Accumulation Part 2 Retrofitting

Ground Rules & Constraints – Asset Accumulation:
Part II Retrofitting

(aka Retrofitting Portfolio to Objective by Criteria (rather than whim and your brother in laws’ suggestions)

Most people’s portfolios consist of what they have been sold – not what they have bought

Assuming the last blog entry Risk Ground Rules & Offsets exercise has been completed relative to each accumulation objective (there should be separate portfolios for for education, slow down (a percentage of standard of living from passive investment sources prior to a work free retirement), retirement etc, the next phase is retrofitting each portfolio. (This is unlike the typical ‘which one, which kind – I thought it was a good thing to buy at the time’ or the liberal cumbaya rationalization ‘I guess the portfolio grew organically,’ retrofitting begins with criteria rather than MSNBC, stock, bond jockeys, or Rachel Madcow compost.)

The journey of discovery consists not of conquering new lands but seeing with new eyes
Marcel Proust

One more time – risk is not making the goal. That said, lowest, below average, average, above average, and high risk is in the eyes of the beholder (until contrasted by the light of the reality of the objective and where you are relative to it.) So, we start with the eyes of the beholder. And risk ‘tolerance’ changes when one sees how far or near he is to achieving, or maintaining the objective as to what is required and assumed (amount, after tax after inflation ‘risk adjusted’ rate of return, start and duration).

In March of 1985, Dick Wollack published in the Digest of Financial Planning Ideas, “The Orange Juice Analogy” relative to what an investment – may provide in terms of “juice.” And to paraphrase, ‘there is only so much juice in the orange.’
Taking the analogy a bit further, no matter how you slice it (regardless of the some planning clients who want ‘certainty, permanence, continuity’ plus 15% or at least 5% after tax after inflation with no volatility’) again there is only so much juice one can squeeze from an orange even if you are a divorce lawyer.

The orange and its limited juice is analogous to what an investment can do to degrees. The juice from the orange can provide whole, part but not all of the following:

· Preservation of nominal capital
· Preservation of purchasing power
· Liquidity
· Restored liquidity (income from an illiquid assets)
· Current taxable income
· Tax sheltered income
· Capital appreciation
· Asset protection (from creditors)
· Tax savings

You can’t have it all – from an investment or radical feminism’s pipe dream. As important as what you need from the investment is what you don’t need and can’t have. The is without recognition of the is not – is snot.

A most mutual fund offering capital appreciation and liquidity most likely doesn’t offer asset protection, and preservation of capital in bad markets. (Thus, out of 8 ounces or juice, maybe 5 oz are capital gains, 1 oz is current income and 2 oz are liquidity.) Bonds may give income, and a deflation hedge but their isn’t much juice left to preserve purchasing power during inflation. (4 oz of current income, 1 oz of preservation of nominal capital, 1 oz of deflation hedge and 2 oz liquidity). Income oriented real estate may throw off sheltered cash flow and give appreciation but one loses liquidity. (4 oz of sheltered income, 2 oz preservation of purchasing power/inflation hedge, 1 oz restored liquidity).

The point is there is only so much juice in the investment orange even using the Jack LaLanne juicer for maximum extraction. If someone tells you otherwise, it’s pulp fiction.

So forget about which individual stock, bond, real estate etc orange, mango, acai, banana, apple (unless from Eve) – and concentrate (pun) on the fruit salad - the portfolio construction per objective process termed retrofitting.

(It should be noted even after retrofitting, the portfolio will be back tested against the aforementioned risks in part I, and forward tested by monte carlo analysis relative to the probability of achieving the particular objective. Enough per objective is a reiterative process – culminating in an Investment Policy Statement per objective reviewed and rebalanced at least annually).

Retrofitting Steps – (The Pyramid Scheme)

1. Create a pyramid creating 5 levels bottom to top
2. The lowest level should be lowest risk and the highest level in your ‘gut’ estimation (at least at this point in the reiterative process of ‘do’ and dodo looping.)
3. At each level put what you see as the two key criteria you desire. (For example, at the lowest level you might put preservation capital and liquidity. Proceed up each level with what you expect that successive rung to provide.)
4. Once #3 is finished place next to the criteria the generic types of instruments that may correspond to the criteria. For example – next to preservation of capital and liquidity – you might put money moneys, short term CD’s etc.
5. Once #4 is done – now place the percentage you wish in each rung of this laddered pyramid
6. Now the tricky part – you need to assess the rate of return for each rung weighted. For example if you say 20% in money markets – and they are yielding 1% - that’s a .2% rate of return for this rung in the portfolio – and that is before taxes!. If in level four, in contrast, you put capital appreciation and liquidity – this might be growth or value mutual funds or ETFs etc. Now what rate of return will you use, 8%, 10% etc? Don’t worry this is just a start.
7. After weighting each rung for rate of return – apply taxes (ordinary rates for income, lower capital gain rates for long term appreciation, and obviously no tax on sheltered income – which is merely deferred.)
8. Now does the rate of return as you have defined your risk and the types of vehicles you have generically selected make your hurdle rate for the objective?
9. Furthermore, given the prior risk exercise of prone and offsets, does this type of portfolio (assuming the hurdle rate of return is met) met your preferred risk prone/offset assessment.
10. Probably not – but so much for the much vaunted ‘risk tolerance’ scales financial planners use without the context of the goal and its requirements.

A couple of other notes

First, there is no current tax consideration relative to the retirement goal as all income and gain is tax deferred until distributed by the plan. Furthermore, a portfolio owned by your kids for their education will have a lower tax burden – but check the rules under 14 and over 14 years of age). Secondly, many have a level below the lowest level in the rung – emergency/deductible fund.

What is this emergency deductible fund? Think 1 or 2 years of cash or cash equivalents to weather terrible markets and not get antsy selling at the bottom (or 7 years if you are a direct descendent of Joseph remembering the 7 fatted cows and 7 emaciate lean cows – 7 good years and 7 bad years). (1) Also, having this emergency fund allows you to take larger deductibles on your homeowners, auto, disability, long term care policies reducing premiums. The savings in premiums from these higher deductibles, wait periods etc. (which are all after tax dollars) are an after tax rate of return planners and clients typically fail to recognize in their rate of return calculations. Add back the savings into rate of return from this self insurance. (And yes, you can argue this may just be a deferral of a cost eventually incurred. Maybe yes, maybe no – so if you want discount the savings to reflect this potential.)

(1) The 7 emaciated cows ate the 7 fatted cows actually losing weight – biblically the first proven trial of the Adkins Diet.

NEXT: IPS (not related to IBS though it can cause it) Investment Policy Statements