Reading 15: Managing Individual ....tor Portfolios －LOS j

The ability to take risk is usually associated with specific goals and time horizons and is more quantitative than willingness to take risk. Willingness to take risk is more subjective from the investors perspective and is therefore more qualitative in nature.

The time horizon of both short- and long-term objectives will have direct consequences on an investors ability to take risk.

The willingness to take risk is related to the psychological characteristics of investors and is best measured in subjective terms.

Institutions as well as individuals should consider a total return perspective. Spending objectives usually represent an income component while growth objectives represent a capital gains component. Even though a client may have a significant current income requirement, attention to portfolio growth is also required. The same is true with respect to inflation. One of the distinguishing factors between individual and institutional investors is time horizon. Institutional investors may have infinite lives, but individuals do not.

The Kreuzs indicate a below average willingness to take risk based on their unhappiness with the 2000-2002 bear market in stocks and an unwillingness to accept a decline in the value of their portfolio of more than 10%.

The ability to take risk is best classified as above average. They have a substantial asset base, a long time horizon, and do not depend on their portfolio to meet their living expenses. Their after-tax income is $150,000(1 - 0.4) = $90,000, which exactly covers their living expenses. Also, their required return is equal to N = 20; PV = $1,200,000; FV = $2,500,000; PMT = 0; CPT I/Y → 3.74% on an after-tax basis, which is equal to 3.74 / (1 - 0.4) = 6.23% on a pretax basis, which is a reasonable return for a balanced portfolio.

Overall, with an above average ability and below average willingness, their risk objective is below average as their willingness to take risk dominates their ability to take risk in determining overall risk tolerance. On the exam, if a conflict arises between willingness and ability to take risk, honor willingness to take risk unless doing so would jeopardize the portfolios ability to meet investor goals.

Procedure 1 is incorrect the process of identifying desired and required returns should take place concurrently ultimately, the investment policy statement must present a return objective that is attainable within the risk constraints of the portfolio. Procedure 2 is also incorrect the investment manager should address both required and desired returns in the IPS, although when balancing the return objective with risk tolerance, the investor may have to dismiss less important objectives and focus on required return, putting less emphasis on desired returns.

Given his age, income, and lifestyle, Piasecki would seem to have a high ability to take risk, which conflicts with his willingness to take risk. Also, his required return cannot be achieved given his willingness to take risk. On the exam, a general rule is to go with clients willingness to take risk unless doing so would jeopardize the portfolios ability to meet the investors goals (going ahead and investing in the Treasury bonds would not be an option). In this case, investor education and a reassessment of portfolio objectives is the best option. The client obviously cannot meet both his return requirement and risk tolerance goals at the same time, so something has to change either the client changes his views on risk through education, or he changes the goals of his portfolio. Taking any of the other three actions would either not meet the required return, or would violate the risk tolerance, so investor education is the key. If you see a conflict like this on the exam, make sure the inconsistency is noted and that you recommend investor education.