PRIVATE WEALTH MANAGEMENT — CFA L3 CHEAT SHEET

Individual Investment Policy Statement (IPS)

RRTTLLU Framework

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Risk Tolerance: The Critical Divergence

When Risk Capacity ≠ Risk Willingness:

• Capacity = ability to financially sustain losses (income, wealth, horizon, liquidity)

• Willingness = psychological comfort with volatility

• IPS reflects: MIN(capacity, willingness)

• Advisor duty: Educate on long-term cost of over-conservatism, but do not override stated preference

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Human Capital

|-------------|------------------------|-----------------------| Key insight: Human capital is an illiquid "bond" — affects appropriate stock/bond mix of financial portfolio. ---

Tax Planning & Asset Location

Return Requirement Calculation

Formula: $$\text{Nominal Return} = \frac{\text{Annual Shortfall}}{PV} + \text{Inflation Rate}$$ Example: $120K annual gap / $5M portfolio + 2.5% inflation = 2.4% + 2.5% = 4.9% real or ~6.0% nominal ---

Tax-Equivalent Yield (Taxable vs. Tax-Exempt)

$$\text{Tax-Equivalent Yield} = \frac{\text{Tax-Free Yield}}{1 - \text{Marginal Tax Rate}}$$ Example: Muni at 3.8%, client in 37% bracket: $3.8\% \div (1 - 0.37) = 3.8\% \div 0.63 = \mathbf{6.03\%}$ (compare to taxable yield) ---

Asset Location Strategy (Tax Efficiency)

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Component	Definition	Key Decision Rules
Return Requirement	Minimum portfolio return to meet goals (living expenses, inflation, growth, bequest)	Express as: after-tax, nominal or real, before/after fees
Risk Tolerance	Risk capacity + Risk willingness	Use the LOWER of the two; educate if client irrationally underestimates capacity
Time Horizon	Investment period per goal; multi-stage (accumulation, early retirement, late retirement)	Longer horizon → higher equity allocation possible
Taxes	Marginal rate, cap gains treatment, tax-deferred/exempt accounts	Use asset location strategy (see below)
Liquidity	Near-term cash needs + emergency reserves	Constrains illiquid allocations (PE, hedge funds, real estate)
Legal/Regulatory	Fiduciary duties, constraints from law/trust documents	Document compliance obligations
Unique Circumstances	Concentrated positions, ESG, family obligations, business ownership	Must be explicitly documented in IPS
Client Type	Human Capital Relevance	Portfolio Implication
Age 30–55, employed	HIGH (PV future income >> financial assets)	Can allocate financial capital more aggressively (income is "bond-like")
Age 60+, retiring	LOW (income nearly realized)	Shift toward lower-risk allocation; financial capital now primary
Retiree with pension	MEDIUM (pension = stable income floor)	Pension acts as implicit bond; can take risk with discretionary assets
Account Type	Best Assets	Rationale
Tax-Deferred (401(k), Trad IRA)	High-turnover, taxable bonds, REITs	Defer all gains/income until withdrawal
Taxable	Low-turnover equities, munis, growth stocks	Minimize current tax; benefit from cap gains rates
Roth (highest priority)	Highest-growth assets	Future appreciation tax-exempt; best tax advantage long-term

Value: +0.5–1.5% annual after-tax return vs. naive placement ---

Key Tax Concepts

Tax Drag

• Definition: Reduction in compound returns due to taxes on income and realized gains

• Minimize via: Low-turnover funds, tax-loss harvesting, strategic asset location

Tax-Loss Harvesting

• Sell at loss → offset gains elsewhere

• Reinvest in similar but not "substantially identical" security (avoid wash-sale rule)

• Lock in losses while maintaining market exposure

• Deduct unused losses up to $3K annually (carry forward indefinitely)

Wash-Sale Rule (US)

• Cannot repurchase same/substantially identical security within 30 days before/after loss sale

• Use similar fund/ETF from different provider

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Quick Decision Checklist

When constructing individual IPS:

• [ ] Return requirement = after-tax, reflects inflation, includes all goals

• [ ] Risk = min(capacity, willingness); educate on mismatch

• [ ] Time horizon = multi-stage; distinguish human capital phase

• [ ] Liquidity = constrains illiquid assets

• [ ] Taxes = asset location + tax-loss harvesting in plan

• [ ] Unique circumstances = documented (concentrated stock, ESG, etc.)

Red flags:

• Return requirement uses pretax numbers → incorrect

• IPS ignores divergence between risk capacity and willingness → suitability issue

• No asset location strategy → leaving tax efficiency on table

• Ignores human capital for 40-year-old → misallocates risk