Completeness portfolio question

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Hi everyone,

Hope everyone’s studies are going well. just a quick question

In the Behavioral Finance book P355, can someone please explain why a client moves from a single low basis stock to holding a diversified portfolio of lower-basis stocks with the completeness portfolio? Thanks

[cpk123]

a single stock with low basis is a high risk stock.

2 reasons …

1. if that stock itself does not do well - his entire wealth is invested in that stock.

2. if the stock does well - and appreciates in value - given his low basis (original cost of purchase) he has high capital gains - so he will incur an extremely high capital gains tax - if he sells the stock

and the bigger reason - CFAI likes diversification - spreading your eggs in multiple baskets … (so you can have multiple small omelettes instead of one gigantic one).

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But why would the cost basis fall even further if the completness portfolio is implemented?

[cpk123]

what they are stating is that you could end up with a completeness portfolio with stocks with even lower cost basis - and that could end up being a risk - because you end up having a tax liability.

" a completeness portfolio incorporates the risk characteristics of the concentrated stock position to build a portfolio such that the combination of the two portfolios tracks the broadly diversified market benchmark to the best extent possible. The completeness portfolio minimizes correlation with the concentrated stock by not including similar industry and sector bets. Capital loss harvesting in the completeness portfolio allows a concurrent sale of the concentrated stock position without a tax liability. Over time, the size of the concentrated stock position is whittled down to zero, whereas the completeness portfolio becomes an index-tracking one." "This strategy is certainly one way for an investor to diversify out of a concentrated position, but it does come with certain risks and costs. First, and most importantly, this strategy is intended to be implemented over time, so the investor continues to retain the company-specific risk of the remaining, albeit a progressively diminishing, concentrated stock position.

Second, in a perfect world (that is, assuming the concentrated stock position does not decrease precipitously early on during this process and the index proxy manager performs well), the best possible result will be that the client moves from holding a single low-basis stock to holding a diversified portfolio of lower-basis (i.e., not current) stocks. Hence, when this diversified market portfolio needs to be liquidated, there could be a tax associated with it."

[ext]

what they are stating is that you could end up with a completeness portfolio with stocks with even lower cost basis - and that could end up being a risk - because you end up having a tax liability.

" a completeness portfolio incorporates the risk characteristics of the concentrated stock position to build a portfolio such that the combination of the two portfolios tracks the broadly diversified market benchmark to the best extent possible. The completeness portfolio minimizes correlation with the concentrated stock by not including similar industry and sector bets. Capital loss harvesting in the completeness portfolio allows a concurrent sale of the concentrated stock position without a tax liability. Over time, the size of the concentrated stock position is whittled down to zero, whereas the completeness portfolio becomes an index-tracking one." "This strategy is certainly one way for an investor to diversify out of a concentrated position, but it does come with certain risks and costs. First, and most importantly, this strategy is intended to be implemented over time, so the investor continues to retain the company-specific risk of the remaining, albeit a progressively diminishing, concentrated stock position.

Second, in a perfect world (that is, assuming the concentrated stock position does not decrease precipitously early on during this process and the index proxy manager performs well), the best possible result will be that the client moves from holding a single low-basis stock to holding a diversified portfolio of lower-basis (i.e., not current) stocks. Hence, when this diversified market portfolio needs to be liquidated, there could be a tax associated with it."

I really appreciate your time and help!

What i’m not understanding is this: let’s say you have a concentrated position at some cost basis today, then you invest in the index to diversify… if you’re buying the index today… why would you end up with an even lower cost basis later?

I guess it has something to do when they say “not current stocks”, meaning their cost basis is < concentrated position’s cost basis?

Why wouldn’t they be current if you’re just investing in the index now to diversify

Thank you!

[cpk123]

you would be investing in the index slowly - not all at once. say you sold X$ of your position (not all) today and bought X$ of other stock … and then do this progressively over time … you might end up with a situation described - where you are buying other lower cost bases stock over time. and hence diversifying your position. You would end up with current cost basis of all other stock only if you sold all of your position and bought all (which is the precipitous situation – decrease precipitously early on).

[crosstheevil]

@cpk123

you would be investing in the index slowly - not all at once. say you sold X$ of your position (not all) today and bought X$ of other stock … and then do this progressively over time … you might end up with a situation described - where you are buying other lower cost bases stock over time. and hence diversifying your position. You would end up with current cost basis of all other stock only if you sold all of your position and bought all (which is the precipitous situation – decrease precipitously early on).

I like this answer, but why the name “completeness”?

Is it because the portfolio is not concentrated anymore with a portion of it tracking an index?

[inchvbeam]

Hi, on this statement from CFAI text in bold, Capital loss harvesting in the completeness portfolio allows a concurrent sale of the concentrated stock position without a tax liability. Over time, the size of the concentrated stock position is whittled down to zero, whereas the completeness portfolio becomes an index-tracking one.”

May I seek anyone’s kind assistance to explain the sentence in bold please? Why isit only in a completness portfolio that you could harvest capital loss?

[cpk123]

you sell a portion of your portfolio at a loss, tax laws allow you to take and adjust that loss against the remaining portfolio gains - so you pay lower taxes. (Do not incur as much or even maybe no tax liability).

[inchvbeam]

@cpk123

you sell a portion of your portfolio at a loss, tax laws allow you to take and adjust that loss against the remaining portfolio gains - so you pay lower taxes. (Do not incur as much or even maybe no tax liability).

Thank you. I understand that any loss in the concentrated stock will allow you to reap tax in capital loss, but that is only if you have capital gains to offset. If the correlation of the concentrated stock versus that of other holdings within the portfolio is low, a drop in the concentrated stock may likely mean that an increase in the other holdings, which thus enables you to reap the capital loss tax.

[S2000magician]

@inchvbeam

If the correlation of the concentrated stock versus that of other holdings within the portfolio is low, a drop in the concentrated stock may likely mean that an increase in the other holdings, which thus enables you to reap the capital loss tax.

This may – _ may _ – be true if you’re talking about the correlation of the assets’ prices. However, if you’re talking about the correlation of the assets’ _ returns _, you cannot say whether a loss in one will likely mean a gain in the other. And in portfolio management, we talk about (or, more accurately, are supposed to be talking about) correlations of _ returns _.

This is the main reason I hate phrase “correlation of assets”; it’s sloppy language, and it leads to sloppy thinking.

[inchvbeam]

@S2000magician

@inchvbeam

If the correlation of the concentrated stock versus that of other holdings within the portfolio is low, a drop in the concentrated stock may likely mean that an increase in the other holdings, which thus enables you to reap the capital loss tax.

This may – _ may _ – be true if you’re talking about the correlation of the assets’ prices. However, if you’re talking about the correlation of the assets’ _ returns _, you cannot say whether a loss in one will likely mean a gain in the other. And in portfolio management, we talk about (or, more accurately, are supposed to be talking about) correlations of _ returns _.

This is the main reason I hate phrase “correlation of assets”; it’s sloppy language, and it leads to sloppy thinking.

Thank you S2000 for your timely reminder and detailed explanations.

[S2000magician]

My pleasure.

It’s interesting (i.e., dismaying) to see how many people – including professors who should know better – who don’t understand the difference between correlation of returns and correlation of prices.

The curriculum is guilty of sloppy language and, consequently, I suspect, sloppy analysis, for precisely this reason. It’s appalling.