The CFA Approach to Coming Up with an Investment Plan

While many of the formulas I learned for the CFA exams are certainly starting to fade from memory, one will never fade. It’s the formula for what to do when someone says:

“Look, I have this pile of money in some funds in my 401k, and I’m contributing more to it each month, but… I don’t really know what I’m doing here. Can you give me some sort of a plan?”

The recipe for devising an investment plan from scratch is one of the crown jewels of Level 3 of the CFA program, and the formula is R R T T L L U. It stands for risk, return, taxes, time, liquidity, legal, and unique. A solid plan balances the constraints of these 7 factors.

Let’s go through a simple example to see how it works. Note that (a) there’s not a particular order in which you have to do the steps and (b) I might do some a little differently than how you have to do them on the exam, just based on my own experience.

So, assume a 45-yr old friend has an IRA worth $165,000 right now to which he’s adding $5,000 per year, and he wants advice. Can we give him a rough plan?

1. Time
How long until he wants to retire? He says 20 yrs. Nothing is expected to change between now and then. He’ll keep working and keep contributing to the account.

2. Liquidity
We can’t just assume we can expose all the $165k to investment risk. Do we need to set some of it aside in a money market in case of emergency? Like maybe $20k and invest the other $145k? He says no, he has a separate rainy day account for that. So, we’ll proceed with investing the whole $165k.

3. Taxes
This is an IRA so the investments will grow tax-free. But when he retires, the withdrawals from it will be taxed. We do some homework and estimate that the tax rate on those will be 25%.

4. Legal
Are there any legal items to consider here? No – maybe if this were an endowment we’d have to distribute a minimum % per year, but this is a private account. Keep moving…

5. Unique
Does he have any special requests? Like including Sharia compliant funds, avoiding tobacco companies, or investing in more socially responsible firms? He says no, but he does want to avoid spending down his nest egg during retirement. He’s 25% Native American and wants to leave the large principal to the American Indian College Fund after his death.

6. Return
How much does the account need to generate each year after he retires? He says $30k per year which, when combined with his social security, should fund all his annual needs. $30k per year is 30 / (1-25%) = $40k pretax. In order not to spend down the principal, we think he can safely remove 4% per year. $40k / 4% = $1M.

This is a simple time value of money entry into Excel or a financial calculator.

PV = -165k, PMT = -5k, FV = 1M, n = 20, solve for the return:


The answer is 8% but we want him to have $30k per year in 2014 purchasing power, so let’s add 1% for inflation. Required return = 8 + 1 = 9% per year.

7. Risk
I know his asset allocation should target 9% per year, but what is his risk tolerance? He says, “if my portfolio ever has a year where it loses significantly more than about 20% of its value, I’ll probably sell everything and never invest again”. That’s a good data point for us. Assuming a normal distribution, it should be rare to get a return 2 standard deviations below the mean, so…

m – 2s > -20
9 – 2s > -20
29 > 2s
14.5 > s

And now we have our answer. We want an asset allocation with an expected return of at least 9% and a standard deviation no higher than 14.5%. Can we find one? In the classroom you can! The reading material always gives you a few asset allocations and their respective statistics in a nice table to pick from.

In the real world, we don’t usually have that nor trust that returns will follow a normal distribution. I’d recommend two resources. One is Portfolio Visualizer where you can roll your own asset allocations and see how they would have done historically. Another is my asset allocation site where I maintain historical return statistics for a few popular asset allocations.

Using the latter, the Coffeehouse allocation looks like a probable fit…


It slightly exceeds the 9% return requirement. I basically skip the bell curve assumptions but instead look at both the predicted “rare, really bad year” using a Pearson distribution (-20.8%) as well as the actual worst year in recent history (-20.2%). So the risk looks to be just around his maximum pain level. We’ll recommend he copy that as closely as possible with index funds. Done!

Bonus: Speaking of risk, what if we couldn’t have found an asset allocation that met his constraints? The rule is you never, never, never try to talk someone into taking more risk than they guide is comfortable. We would have had to go back to the spreadsheet and figure out a plan for increasing his annual contribution, working a few more years before retiring, or both in order to make that future $1M target.

And what do you do with a client who wants to shoot for the moon and take more risk than he should? In that case it is assumed you can talk sense into them with some additional counseling, perhaps by showing mathematically how they’re trading an almost guaranteed nice retirement for a 50/50 chance of eating either caviar or cat food.