kim226

Sam and Ellen Smithson have both recently retired after numerous years of working as a heart surgeon and pediatrician, respectively. The Smithsons were not able to have children, so they devoted their lives to helping others through their professional and charitable activities. Sam was involved in the local “Pantry Pass,” an organization that gathered food items for distribution to the needy. Ellen was involved in her local “Housing for the Homeless,” chapter. Both served their respective organizations in direct service and board member capacities.
The Smithsons’s professional activities generated high incomes that were beyond living expenses, which could easily be described as comfortably frugal. Over the years, a tax deferred retirement savings account in the amount of $4,000,000 has been accumulated. During discussions with Marcus Medley, CFA, Sam and Ellen mentioned the following:

• Our living expenses are minor and are estimated to be no greater than $150,000 per year. As a result, we consider our retirement portfolio to be large both in absolute and relative terms
• We are both in good health and have at least another 20 to 25 years of life expectancy. We do not foresee any major medical expenses, either chronic or acute, over the horizon.
• We have no debts and wish not to undertake decisions that would require us to borrow.
• After we die, we would like to leave the remainder of our portfolio equally to the charities with which we have been involved over all these years. One of our objectives is to maximize those funds transferred.
• Neither one of us has a high tolerance for risk and, for the most part, our retirement savings have been in low-risk type investment vehicles. Our investment portfolio decisions have been made in congruence with our feelings of enhancing the opportunities available to our fellow man.
• When we have invested in equity-type securities, we have focused investing in socially responsible funds. Firms that sell tobacco, firearms, alcohol, or have been cited by the EPA for environmental damage are not allowed in our portfolio.

Medley has taken the Smithsons’ personal statements, as well as economic activity forecasts, and is attempting to formulate an investment policy statement, as well as recommend some general asset allocation guidelines.
Medley first decides to classify the Smithsons along general investment personality typing guidelines. Which of the following personality types best describes the Smithsons?

A) Cautious.

B) Methodical.

C) Individualist.

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The Smithsons have indicated they are somewhat risk averse. Additionally, statements referring to investment decisions being made parallel with feelings, and not necessarily those based on thinking, are congruent with a cautious personality type.

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In formulating the risk objective statement, Medley must formalize the Smithsons according to their ability and willingness to take on risk. Regarding the Smithsons’ risk profile, Medley appears able to make the direct statement that the Smithsons are:

A) able and willing to take above average risk.

B) able to take above average risk, but are only willing to take below average risk.

C) only able to take below average risk, but are willing to take above average risk.

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Given the data regarding the Smithsons’ situation, it appears that they are able to take above average risks (large absolute and relative sized portfolio), but only willing to take below average risks (“neither of us has a high tolerance for risk”).

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One additional factor Medley believes important is the Smithsons’ stage of life. Which of the following best represents the Smithsons’ stage of life?

A) Early.

B) Latter.

C) Mid.

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The Smithsons are obviously in the latter stage of their life cycle. Even though both appear to have a long life left, they are retired and are looking at how their legacy will be remembered after they die.

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According to the Smithsons’ risk profile created by Medley, a general asset allocation that would fit well with their objectives is:

A) an aggressive growth asset allocation so that the largest amount of funds will be left to their charities.

B) a portfolio heavily weighted toward risk-free securities to minimize possibilities of making inappropriate investments.

C) an asset allocation that focuses on generating a conservative total return to meet not only minimal current needs, but also the objective of maximizing the funds transfer to the charities.

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An asset allocation that focuses on total return would appear to best meet the Smithsons’ objectives given the apparent disconnect between ability and willingness to take risk. The total return approach provides an appropriate balance between meeting their retirement needs and providing for the charities.

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Which of the following investments would NOT be appropriate in the Smithson's portfolio?

A) Options.

B) Commodities.

C) Municipal bonds.

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Since their retirement savings account is tax deferred it would not be appropriate to put a tax free investment such as a municipal bond into an already tax deferred account. Municipal bonds are most effective in the taxable accounts of higher income earners. The other investment choices may be appropriate in the portfolio if added in the appropriate proportions and used to diversify the portfolio reducing the overall risk of the portfolio.

kim226

Desired return objectives are those return levels associated with:

A) major goals.

B) secondary goals.

C) vacation home goals.

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Desired return objectives are associated with secondary goals. Desired returns may be lowered if there is a disconnect between risk tolerance and return objectives.

kim226

Risk objectives should be evaluated during which stage of the investment policy statement process? Concurrently with the:

A) capital market expectations formations.

B) investment strategy decision.

C) return objectives.

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Discussions of risk objectives should occur simultaneously with those of return objectives.

kim226

Return requirements are those return levels associated with returns needed to meet:

A) secondary goals.

B) educational goals.

C) major goals.

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Return requirements are returns needed to attain major goals.

kim226

Which of the following statements distinguishes the ability to take risk from the willingness to take risk? The:

A) ability to take risk is more qualitative in nature whereas the willingness to take risk can be measured in a quantitative nature.

B) ability to take risk is more amenable to quantitative measures whereas the willingness to take risk is more qualitative in nature.

C) willingness to take risk is connected with primary goals and objectives.

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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 investor’s perspective and is therefore more qualitative in nature.

kim226

Jessica Paskiet, a portfolio manager for Porthouse Investment Management is drafting an investment policy statement for her new client, Kenneth Moon. Which of the following procedures should Paskiet follow when drafting the risk and return objectives for her client?

Procedure 1:	Consider the client’s risk tolerance and return objective separately from one another.
Procedure 2:	Focus on the investor’s required returns only, as desired returns are not important when drafting the IPS.

With regard to the procedures Paskiet has proposed:

Procedure 1

Procedure 2

A) Incorrect Correct

B) Correct Incorrect

C) Incorrect Incorrect

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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.

kim226

Dan Kreuz, age 35, is a supervisor with BHS Consumer Finance and earns an annual salary of $95,000 per year before taxes. His spouse, Szeren Kreuz, age 36, is a marketing manager for a firm specializing in rental property, and earns $55,000 per year. Dan and Szeren recently inherited $800,000 from Szaren’s father’s estate. In addition to their income and their inheritance, the Kreuz’s have accumulated the following assets:

• $10,000 in cash
• $150,000 in stock and bond mutual funds
• $240,000 in BHS common stock.

The Kreuz’s annual living expenses are $90,000 per year and their tax rate is 40 percent. After-tax salary increases will offset any future increases in living expenses.

In a discussion with their financial advisor, Joel Douglas, the Kreuz’s express concern about having enough assets for a comfortable retirement. The Kreuz’s make the following comments to Douglas:

• We want to retire in 20 years.
• We were very uncomfortable with the decline in the stock market from 2000-2002, and cannot tolerate a drop in our investments of more than 10% in any given year.
• We do not plan to have children.

After the discussion with Douglas, he goes back to his office to prepare an investment policy statement for the Kreuz’s. He determines that to meet their goals, they will need $2,500,000 in 20 years. Which of the following is the most appropriate description of the risk objective for the Kreuz’s?

Willingness to Take Risk

Ability to Take Risk

Overall Conclusion

A) Below Average Below Average Below Average

B) Below Average Above Average Below Average

C) Below Average Above Average Above Average

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The Kreuz’s 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 portfolio’s ability to meet investor goals.

kim226

Brad Piasecki is a successful 35 year old executive in the technology industry with a company that is growing rapidly. Piasecki has a pre-tax income of $150,000 per year, and manages to live well below his means. Piasecki is currently saving for both his retirement, which will take place in 30 years, as well as funding his daughter’s college education, which will begin in 15 years. Piasecki’s investment manager has determined that based on contributions to his portfolio, Piasecki requires at a minimum, an 8 percent annualized return on his investments in order to meet his goals. He also states that Piasecki should invest in a diversified stock and corporate bond portfolio that provides total return with an emphasis on capital gains. When his investment manager gives Piasecki his recommendations, Piasecki replies “I have seen too many of my colleagues buy risky stocks and have their portfolios wiped out. I only want to buy Treasury bonds for my portfolio.” Piasecki checks the yields on Treasury bonds, and sees that best yield he can obtain is 4.5 percent. Which of the following would be the best course of action for Piasecki’s investment manager?

A) Recommend investor education and a reassessment of portfolio objectives since the investor’s view is inconsistent with his goals and ability to take risk.

B) Invest 50 percent in Treasury bonds and 50 percent in the diversified stock/corporate bond portfolio to provide a balance between Piasecki’s risk tolerances and required return.

C) Invest in the Treasury bonds since willingness to take risk always supersedes ability to take risk.

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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 client’s willingness to take risk unless doing so would jeopardize the portfolio’s ability to meet the investor’s 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 two 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.

kim226

The willingness to take risk is best judged by the:

A) subjective nature of the perspective investments.

B) psychological profile of the investor.

C) financial profile of the investor.

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

kim226

Which of the following statements regarding institutional and individual investors is CORRECT?

A) Institutions and not individual investors should focus on total return.

B) Time horizon factors are typically more crucial to individuals than institutions.

C) Portfolio growth is not important when an individual client is faced with substantial income requirements.

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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.