Financial Advice and Investment Decisions: A Manifesto for Chang

ABOUT THIS BOOK
A practical guide to adapting financial advice and investing to a post crisis world

There's no room for "business as usual" in today's investment management environment. Following the recent financial crisis, both retail and institutional investors are searching for new ways to oversee investment portfolios. How do you combine growth with a focus on wealth preservation? This book offers you a fresh perspective on the changes in tools and strategies needed to effectively achieve this goal.

Financial Advice and Investment Decisions provides today's investment professionals with the conceptual framework and practical tools they need to successfully invest in and manage an investment portfolio with wealth preservation as a key concern. While there are many qualitative discussions, the authors present strong quantitative theory and practice in the form of small conceptual models, simulation, and empirical research.

-A comprehensive guide to properly managing investments with a focus on matching security and growth goals with the needs of the investor
-Blends insights gleaned from portfolio management practices used prior to the market mayhem of 2007-2009 with cutting-edge academic and professional investment research
-Includes innovative and wide-ranging treatment of subjects such as augmented balance sheets, the efficiency of markets, saving, spending, and investing habits, and dealing with uncertainty
-Description of opportunities for improving the investing environment

The recent financial crisis has opened our eyes to the need for improving the way we invest. This book will put you in a better position to excel in this new economic environment.


TABLE OF CONTENTS
Preface xi

Acknowledgments xiii

About the Authors

CHAPTER 1 Why Do We Need Better Financial Advice? 1

The Individual 2

Organizational Influences 4

The Rest of the Story 10

CHAPTER 2 The Evidence Is Compelling 13

Financial Planning 13

Your Most Important Investment Decision 14

Option Payoffs are Not Simple 18

After-Tax Payoffs are Not Simple 20

Our Primitive Brains and Monkey See, Monkey Do 21

Others’ Agendas and the Perils of the Ivory Tower 22

CHAPTER 3 The Extended Balance Sheet Approach to Financial Planning 25

The Simplest Model 25

The Stochastic Dynamic Programming Alternative 29

The Mental Accounting Alternative 30

The Extended Balance Sheet 31

A Financial Planning System 37

CHAPTER 4 Properties of Mostly Efficient Markets 43

Multi-Agent Emergent Behavior 44

Why Security Returns are Difficult to Predict 46

Markets Bubble and Crash 48

Investment Implications of Market Characteristics 57

CHAPTER 5 Growing Discretionary Wealth 59

The Discretionary Wealth Approach 59

Elements of the Approach 60

Appropriate Markowitz Risk Aversion 73

CHAPTER 6 Coping with Uncertain Knowledge 79

Interpretation of Probability 80

Bayesian Probability Fundamentals 81

Resisting Forecasting Overconfidence 87

Making Estimates More Robust to Extreme Observations 95

Taking Context into Account 99

Making Better Use of Information in Decisions 102

CHAPTER 7 Controlling Investing Behavioral Biases 105

Facing Up to Complexity 106

Promoting Independent Thinking 115

Controlling Organizational Biases 117

CHAPTER 8 Tax Efficient Investing 121

Context 121

Taxes that Affect Investment Returns 123

General Principles of After-Tax Investing 131

Measurement of After-Tax Performance and Benchmarks 140

CHAPTER 9 Matching Investment Vehicles to Needs 143

Revisiting Risk Aversion 144

Taxes Again 146

Diversification 148

Higher Moments 150

Implementation 155

CHAPTER 10 Active vs. Passive Strategies 167

Pricing Efficiency and the Active–Passive Debate 169

CHAPTER 11 Performance Measurement 185

Relating Measurement to Purpose 185

Spending Control 187

Measurement for Individual Passive Investing 190

Performance Reporting for Active Investors 197

Delegating Your Investments Based on Measurements 208

Measuring vs. Evaluating Performance 213

CHAPTER 12 Organizational Investing 217

Representative Investing Organizations 217

Delegating Superior Investing Results 232

Motivating Organizational Benefits 241

CHAPTER 13 Financial Advice and Society 243

Social Ideals and Financial Problem Symptoms 245

Redesigning Society with Better Financial Advice 248

And in Conclusion… 274

APPENDIX A

Traditional Asset Classes and Alternative Assets 275

Asset Class Defined 275

Common Stock Asset Classes 276

Real Estate 278

Alternative Assets 280

APPENDIX B

Bond Features, Yield Measures, and Risks 287

Features of Bonds 287

Yield Measures and their Limitations 289

Call and Prepayment Risk 296

Credit Risk 297

APPENDIX C

Probability Distributions Commonly Used in Investment Management 301

Normal Distribution 301

Student’s t-Distribution 303

Stable Distributions and Stable Paretian Distributions 303

APPENDIX D

Useful Financial Planning Formulas 305

Working with Present Values 305

Determining the Required Savings-to-Income Ratio 305

Taking Initial Investments and

Needed Retirement Income Reduction into Account 306

Investment Return Mean and Variance 307

Deriving an Estimate of Discretionary Wealth Growth Rate 307

Estimating Appropriate Expected Return for Compounding 308

References 311

Index 321


ABOUT THE AUTHORS
Jarrod W. Wilcox, PhD, is President of Wilcox Investment, and investment and financial planning services company emphasizing financial planning and effective risk management to promote sustainable growth, preservation of capital, and income. Wilcox Investment is an SEC-registered investment advisor. Jarrod is a former member of the faculty at MIT’s Sloan School of Management.

Frank J. Fabozzi, PhD, CFA, is Professor of Finance at EDHEC Business School and a member of the EDHEC-Risk Institute. Prior to joining EDHEC, he held various professional positions in finance at Yale University’s School of Management from 1994 to 2011 and was a visiting professor of finance and accounting at MIT’s Sloan School of Management from 1986 to 1992. He is also Editor of the Journal of Portfolio Management.