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Steve Smith is 55 years old. He has just been promoted to VP of manufacturing of a well established manufacturing conglomerate. Recently, Smith received a substantial inheritance from a wealthy relative. Given this information, how would Smith be classified along a risk tolerance spectrum?

A)	Moderate-to-high.

B)	Low-to-moderate.

C)	Very high.

D)	Not enough information to tell.

Steve Smith could be classified on the low-to-moderate range of a risk tolerance spectrum. His age classifies him as getting closer to retirement. His sources of wealth have been attained through relatively passive means (inheritance and well-established conglomerate). His perception of wealth, however, may be high given the recent inheritance and may indicate a moderating risk stance.

Kent Andling is 55 years old and recently sold his high tech manufacturing company, which was started in his fathers basement 35 years ago. Andlings two children are grown and have been featured in recent entrepreneur magazine articles as up and coming entrepreneurs. How would Andling be classified given this brief profile?

A)	Low-to-moderate risk tolerant.

B)	Moderate-to-high risk tolerant.

C)	Ultraconservative risk tolerant.

D)	Not enough information to tell.

Although Andling is approaching the latter stage of life, his participation as an entrepreneur of a high-tech manufacturing firm indicates knowledge of risk-taking activities. Apparently, he has brought up his children to understand risk-taking activities, too. These factors indicate a moderate-to-high risk tolerant profile.

Which of the following is a reason why psychological profiling is important for understanding individual investor behavior?

A)	Investor forecasts reflect all relevant information pertaining to the value of a security.

B)	Investors focus on individual asset risk/return characteristics as well as how the individual asset interacts with other assets in the portfolio.

C)	Investors are loss averse.

D)	Investors are assumed to only select portfolios that maximize a return for a given level of risk.

Psychological profiling is important because investors tend to exhibit certain psychological characteristics which are not rational and are not consistent with modern portfolio theory. One of these psychological characteristics is loss aversion, which means that investors would prefer larger uncertain losses to smaller certain losses (risk seeking behavior). The concept of loss aversion conflicts with the assumption of risk aversion under modern portfolio theory, which says that investors minimize risk for a given level of return. Note that the other answer choices are all assumptions under modern portfolio theory (MPT).

In creating an investment policy statement, a portfolio manager needs to be aware that an investors psychological profile may impact:

A)	the investors risk tolerance and return objective.

B)	the investors risk tolerance only.

C)	the investors return objective only.

D)	neither the investors risk tolerance nor their return objective.

Psychological profiling is important for understanding individual investor behavior because defense mechanisms of the brain often cause investors to violate standard finance assumptions (MPT), resulting in irrational decisions. These psychological tendencies can impact client preferences, goals and constraints. When constructing an investment policy statement, these psychological preferences can have a direct impact on a clients willingness to take risk as well as their desired return.

Amy Tillman and Josh Northrup are portfolio managers for Parquet Asset Management. Tillman and Northrup are discussing the process their firm uses to identify an individual investors objectives and constraints, and ultimately construct an investment policy statement. Tillman makes the following statements to Northrup during the course of their conversation:

A)	Statement 1 is correct; Statement 2 is correct.

B)	Statement 1 is incorrect; Statement 2 is correct.

C)	Statement 1 is incorrect; Statement 2 is incorrect.

D)	Statement 1 is correct; Statement 2 is incorrect.

Psychological/behavioral patterns can have a significant influence on an investors decision making process. Statement 1 is incorrect the role of a portfolio manager is not to eliminate the effect of these psychological patterns on decision making, but to know and understand the investors situation, and use these psychological characteristics when discussing risk and return objectives with the client. The client may need education, but the psychological characteristics a client has should be a key consideration when setting risk and return objectives. Statement 2 is correct. Asset segregation refers to focusing on individual assets instead of evaluating the assets impact on the portfolio. Asset segregation tends to lead to the investor taking on more risk than is necessary in their portfolio the investor may dismiss a particular asset because it is too risky however, in a portfolio context, the asset would actually reduce the risk of the portfolio as a whole.

Statement 1:	Since investors tend to exhibit irrational, psychological characteristics, the investor should be educated so that these characteristics are put aside and rational expectations can be the sole determinant of the investors risk and return objectives.

Statement 2:	Investors that exhibit the characteristic of asset segregation may tend to take on more risk than necessary in their portfolios.