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We use a variety of analysis tools to help develop investment plans and to manage assets on an on-going basis. These tools make use of *sound*, well researched, *investment principles* as well as *proven analytical techniques*. *Few investment advisers* that cater to families, individuals, and small businesses will likely have the expertise to effectively use such tools to assist their clients

For a given level of risk (volatility), many portfolios made up of various mixes of asset classes can be constructed. However, *only certain portfolios will offer the maximum expected return for the level of risk chosen. These are called efficient portfolios*. An *inefficient portfolio means*, for a given level of risk, *you are leaving money on the table*-which can be very costly to you over the long-term.

To determine the asset mix for an efficient portfolio one must look at the expected return of an asset class, its expected volatility, and how its return varies with the return movements of all the other asset classes. Through analysis of historical statistics going back 30 years or more, such projections for each asset class can be made. Then using computerized optimization calculations, efficient portfolios can be defined for each level of expected risk. *Transitioning to an efficient portfolio increases the chances that you will obtain higher returns for a given level of expected risk*.

Suppose *you want to estimate the value of your investment portfolio 20 years from now*. During that 20 years you will add savings during most years, occasionally withdraw some money for special needs, and periodically adjust your asset mix (which changes your risk/return profile). What is the estimated value of your investment portfolio after 20 years?

Traditionally, *most attempts at such projections assumed perfect certainty in the future*. This assumes you can predict exactly how much you will save each year in the future, exactly how much you will withdraw for special needs, and that the financial markets will experience no volatility. *Since these assumptions do not reflect reality, the resulting projections rarely predict what later happens very well*. This has soured many people on the usefulness of long-term projections of any kind.

The alternate approach is to *include the effects of uncertainty in the forecasting model*. The techniques of how to do this are well established through research in the fields of probability, statistics, and sampling. Thus, *uncertainties in your savings rate, your withdrawals, in investment returns, and in asset mix changes can be modeled* using computerized simulation techniques. The estimate of future investment values is not a single point, but rather a range of outcomes that have various chances of occurring. Most people are more concerned about the downside risks-and *this approach provides useful information on the chances of downside scenarios occurring*.

*Taxation has a major affect on investment returns*. Various choices you make will have a major effect on the long-term after-tax return you will achieve. Due to the complex nature of the Federal tax code (and sometimes the state tax code), properly dealing with taxation *requires very careful analysis*. Without such analysis, one is just "shooting from the hip" in making taxation related investment decisions. Factors that may be considered include:

- Long term capital gains have a lower tax rate than ordinary income.
- Long term capital gains have different tax rates depending on the holding period and the ordinary tax bracket you are in.
- Unrealized capital gains are not taxed.
- Each of the major account types (tax-free, tax-deferred, taxable) has tax treatment that must be modeled. For instance, it is possible that an investment plan can be developed that will result in lower after-tax returns in a taxable account than in a tax-deferred account.
- The turnover and yield characteristic of portfolios in taxable accounts will greatly effect the after-tax returns.
- Mutual funds must distribute net capital gains, but are prohibited from distributing net capital losses.
- Capital gains on your house have special rules.
- Capital losses can be used to offset capital gains.
- Net capital losses can be used to offset up to $3,000 of ordinary income.
- Federal tax rates will change over the next 5 years.
- State income tax rates need to be factored in.

There's more, but you get the idea. *We take care to model the relevant effects of taxation in developing your investment plan and in providing on-going management of your assets*.

Please note: (1) no employees of Alban Investment Management, LLC are tax professionals and (2) Alban Investment Management, LLC recommends that investors contact their own tax advisors with respect to tax issues.

*Inflation has a major impact on how to interpret projected investment returns*. Projections can be made in inflated dollars or in constant dollars (that eliminate the portion of the investment returns due to inflation). *Constant dollars make it easier to see what the purchasing power of future investment dollars will be*.

Suppose you start with $100,000 that you invest in a portfolio expected to return 8% over the long term. Inflation is expected to be 2.5% per year. After 20 years, you can expect to have $466,000 in your account in inflated dollars. However, in constant dollars you will have $284,000-which is still good-but it's 40% less than the inflated amount. The difference between the two values is solely due to the influence of inflation. The $466,000 twenty years from now will probably purchase about the same amount of goods and services as $284,000 will today. Actually, assuming productivity increases, it may buy more in twenty years than today-but consider that a bonus if it does.

*Creating constant dollar forecasts involves care that the expected investment returns are consistent with the expected inflation rate*.

The *intrinsic value of a security is the discounted present value of the expected future cash flow* associated with that security. In both practice and theory, cash flow has been shown to be the dominant factor in securities valuation. Warren Buffet, the most successful investor of our era, has used intrinsic value theory with great success. Of course, expected cash flow is based on judgments about the future-and few of us have the quality of judgment of Warren Buffet.

Nevertheless, the intrinsic value framework is a very useful way to approach securities valuation because it focuses our attention on the *key factor: future cash flow*. Thus, before recommending specific stocks, we attempt, when practical, to estimate future cash flows. *If the market price is below the estimated intrinsic value, the stock becomes a candidate for a buy recommendation*.

The practical details of estimating future cash flows for a company are often very complex due to the complicated nature of accounting standards, taxation and the often overly optimistic forecasts made by companies' management. It is part science, part judgment, and part luck.