Reading 20: Goals-Based Investin....avioral Finance－LOS c 2008, protection, matching, absolute

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CFA Institute Area 3-5, 7, 12, 14-18: Portfolio Management
Session 4: Private Wealth Management
Reading 20: Goals-Based Investing: Integrating Traditional and Behavioral Finance
LOS c: Justify the use of absolute performance and cash flow matching objectives to meet the goal of lifestyle protection.

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Which of the two strategies for meeting lifestyle-based objectives results in a frontier of risk and reward, and under what circumstances would the alternative be more desirable?

A) Monte Carlo simulations generating a large number of potential outcomes from asset allocation strategies (also referred to as lifestyle protection strategies) result in a frontier of risk and reward. The alternative, a fixed investment horizon strategy, would be more appropriate when the investment horizon is known with reasonable certainty and maintaining as much upside potential as possible is seen as being of critical importance.

B) Monte Carlo simulations generating a large number of potential outcomes from fixed horizon strategies (also referred to as lifestyle protection strategies) result in a frontier of risk and reward. The alternative, an asset allocation strategy, would be more appropriate when maintaining as much upside potential as possible is seen as being of critical importance.

C) Monte Carlo simulations generating a large number of potential outcomes from fixed horizon strategies (also referred to as lifestyle protection strategies) result in a frontier of risk and reward. The alternative, an asset allocation strategy, would be more appropriate when meeting some minimum objective is seen as being of critical importance.

D) Monte Carlo simulations generating a large number of potential outcomes from asset allocation strategies (also referred to as lifestyle protection strategies) result in a frontier of risk and reward. The alternative, a fixed investment horizon strategy, would be more appropriate when the investment horizon is known with reasonable certainty and meeting some minimum objective is seen as being of critical importance.

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Answer and Explanation

Monte Carlo simulations generating a large number of potential outcomes from asset allocation strategies (also referred to as lifestyle protection strategies) result in a frontier of risk and reward. This is analogous to the efficient risk-return frontier concept in traditional finance.

The alternative, a fixed investment horizon strategy, would be more appropriate when the investment horizon is known with reasonable certainty and meeting some minimum objective is seen as being of critical importance. Asset allocation strategies are more appropriate when the investor has the ability to make up any shortfall, or when retaining the potential to reach the maximum objective is important.

Monte Carlo simulations generating a large number of potential outcomes from asset allocation strategies (also referred to as lifestyle protection strategies) result in a frontier of risk and reward. This is analogous to the efficient risk-return frontier concept in traditional finance.

The alternative, a fixed investment horizon strategy, would be more appropriate when the investment horizon is known with reasonable certainty and meeting some minimum objective is seen as being of critical importance. Asset allocation strategies are more appropriate when the investor has the ability to make up any shortfall, or when retaining the potential to reach the maximum objective is important.

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The risk of failing to meet specified financial objectives is often called:

A) truncation risk.

B) attenuation risk.

C) semideviation risk.

D) shortfall risk.

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Answer and Explanation

The risk of failing to meet specified financial objectives is often called shortfall risk, which is the probability associated with failure.

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Behavioral investors are generally more concerned with:

A) realizing pride, which suggests that expected return is more important than risk to these investors.

B) volatility of returns, which suggests that standard deviation is the best measure of risk.

C) avoiding losses, which suggests that risk of loss may be the best measure of risk.

D) fear of regret, which suggests that the prospect for outperforming a benchmark is the primary concern for these investors.

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Answer and Explanation

Behavioral investors are generally more concerned with avoiding losses, which implies that risk of loss may be the best measure of risk.

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Lifestyle objective-based investing attempts to quantify risk in terms of the:

A) semideviation of returns relative to a goal.

B) ramifications of failing to meet specified objectives.

C) standard deviation of returns vs a benchmark.

D) covariance of the identified lifestyle goals.

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Answer and Explanation

Lifestyle objective-based investing attempts to quantify risk in terms of the ramifications of failing to meet specified objectives.

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Suppose that we have plotted a set of hypothetical investment outcomes relating to various asset allocations, in terms of expected final account value and probability of failing to reach an objective. The investors objective is then to:

A) select the option that minimizes the overall risk of failure.

B) select the option that maximizes the anticipated return and upside potential.

C) select the outcome that will provide at least a 50 percent chance of realizing the most important goal.

D) select the optimal tradeoff between risk of failure and the reward of final account value.

Answer and Explanation

The investors objective is to select the optimal tradeoff between risk of failure and the reward of final account value.

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Suppose that we have plotted a set of hypothetical investment outcomes relating to various asset allocations, in terms of expected final account value and probability of failing to reach an objective. This is analogous to:

A) the role of a replicating portfolio in option pricing theory.

B) the measurement of interest rate risk for a conventional bond.

C) a plot of the efficient frontier in traditional finance.

D) the determination of a hedge ratio using futures contracts.

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Answer and Explanation

This is analogous to a plot of the efficient frontier in traditional finance.

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As opposed to traditional finance, behavioral finance assumes that investors will seek some asset combination that will:

A) minimize the risk of a negative lifestyle outcome.

B) maximize the expected positive lifestyle outcome.

C) optimize the tradeoff between shortfall risk and expected value.

D) minimize standard deviation risk instead of shortfall risk.

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Answer and Explanation

As opposed to traditional finance, behavioral finance assumes that investors will seek some asset combination that will optimize the tradeoff between shortfall risk and expected value.

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Which of the following is most reflective of absolute performance measurement?

A) An objective stated in return over the risk-free rate.

B) An estimated return based upon the probability of exceeding a benchmark.

C) An estimate of the probability that college will be unaffordable.

D) A benchmark that provides an estimate of future risk-adjusted returns.

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Answer and Explanation

A goal of accumulating funds that will be sufficient to pay for college expenses is an absolute objective. All of the others are relative objectives.

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The behavioral finance view assumes that objectives are best defined in absolute terms because:

A) absolute returns are ordinarily easier to achieve because they are readily understood.

B) relative returns cannot be used for lifestyle objectives.

C) specifying relative returns makes it much more difficult to specify a benchmark and to know if the benchmark has been outperformed.

D) it can be difficult for investors to interpret the connection between statistical objectives, and the probability that they will achieve their goals.

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Answer and Explanation

The behavioral finance view assumes that objectives are best defined in absolute terms because it can be difficult for investors to interpret the connection between statistical objectives, and the probability that they will achieve their goals.