CFA Level 1

. Unit 10: Portfolio Management and Wealth Planning

UOLLB CFA Top Notes
Level 1 Exam

Unit 10: Portfolio Management and Wealth Planning
Table of Contents
Asset Allocation................................................1
Life Cycle Investment Goals.............................1
Portfolio Management Process..........................1
Content of Policy Statement..............................2
Portfolio Management.......................................2
Portfolio Variance (P2).....................................3
Asset Pricing Models........................................3
Comparison of CML and SML.........................5
Relaxing the Assumption Underlying SML......5
Asset Allocation
Preliminary Investment Plans
 Various types of insurance
 Cash reserve
Life Cycle Net Worth and Investment
Strategies
Accumulation Phase
 Early to middle years of career
 Small net worth
 High risk investment
Consolidation Phase
 After the midpoint of career
 High net worth
 Moderate risk investment
Spending Phase and Gifting Phase
 After retirement
 No income
 Low risk investment

 Higher-risk investment is recommended
Lower-priority Goals
 Financial objectives are unimportant
 Highest-risk investment is recommended
Portfolio Management Process
Policy Statement
 Focus on investor's short- and long-term needs
 Learn about his investment history and expectation
Examination of Conditions
 Examine current and project financial /
economic / political / social conditions
 Focus on short- and long-term expected conditions for constructing the portfolio
 Construction of Portfolio
 Construct the portfolio based on the conditions and the investor's objectives and
 Meet the investor's needs at minimum risk levels

Life Cycle Investment Goals
Near-term & High-priority Goals
 Shorter-term necessary financial objectives
(e.g. housing)
 High-risk investment is not recommended
Long-term & High-priority Goals
 Longer-term important financial objectives
(e.g. early retirement)

Continual Monitoring
 Monitor and update investor's needs and environmental conditions
 Evaluate portfolio performance
Advantages of Policy Statement
 Understand and articulate realistic investment goals
 Set standards for evaluating portfolio 1 CFA Level 1

. Unit 10: Portfolio Management and Wealth Planning

performance
 Protect investors from inappropriate investments of the portfolio manager
 Prevent costly delays in case of change in portfolio personnel

 Investors maximize their expected utility over a given investment horizon and their indifference curves exhibit diminishing marginal utility
Risk as Variance
 Investors measure risk as variance (standard deviation) of expected returns

Content of Policy Statement
Investment Objective (Risk and Return)
 Capital preservation
 Capital appreciation
 Current income
 Total return
Investment Constraints
 Liquidity
 Time horizon (near-term / long-term / highpriority)
 Tax concern
Marginal Tax Rate (MTR)
 Part of each additional dollar in income that is paid as tax
 MTR = Total Tax Payment / Taxable
Income
Average Tax Rate
 = Total Tax Payment / Taxable Income
After-tax Income Return
 = Pre-tax Income Return  (1 - Marginal Tax
Rate)
Equivalent Taxable Yield (ETY)
 Yield needed on a taxable investment to match the tax-free return offered on a municipal bond
 ETY = Municipal Bond Yield / (1 - MTR)
Portfolio Management
Assumptions of Markowitz Portfolio Theory
Returns Distribution
 Investors look at each investment opportunity as a probability distribution of expected returns over a given investment horizon
Utility maximization

Risk / Return
 Investors make all investment decisions by considering only the risk and return of an investment opportunity
Risk Aversion
 For a given risk level, investors prefer higher returns to lower returns; for a given level of expected return, investors prefer less risk to more risk
Efficient Portfolio
 Portfolio is considered to be efficient if no other portfolio offers higher expected return with the same or lower risk.
Rate of Return on Individual Stock
 Price under Event 1 (P2)
 Price under Event 2 (P1)
 Price under Event N (PN)
 Rate of Return under Event A (R1)
 Rate of Return under Event B (R2)
 Rate of Return under Event N (RN)
 Cash Flow during the Holding Period (D)
 R1 = (P1 - P0 + D) / P0
 R2 = (P2 - P0 + D) / P0
 RN = (PN - P0 + D) / P0
Expected Rate of Return on Individual Stock
 Probability of Event 1 (P(1))
 Probability of Event 2 (P(2))
 Probability of Event N (P(N))
 E(R) = P(1)  R1 + P(2)  R2 + … + P(N) 
RN
Expected Rate of Return on Portfolio (3
Stocks) (E(RP))
 Expected Rate of Return for Stock A (E(RA))
 Expected Rate of Return for Stock B (E(RB))
 Expected Rate of Return for Stock C (E(RC))
 Weight of Stock A (A)
 Weight of Stock B (B)
 Weight of Stock C (C)
 E(RP) = A E(RA) + B E(RB) + C E(RC)
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