Reading 54: Basics of Portfolio Planning and Construction-LO 2011, capacity, investor, ability, between

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Session 12: Portfolio Management
Reading 54: Basics of Portfolio Planning and Construction

LOS d: Distinguish between the willingness and the ability (capacity) to take risk in analyzing an investor's financial risk tolerance.

 

While assessing an investor’s risk tolerance, a financial adviser is least likely to ask which of the following questions?

A) “What rate of investment return do you expect?”

B) “How much insurance coverage do you have?”

C) “Is your home life stable?”

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While the degree of risk tolerance will have an affect on expected returns, assessing the risk tolerance comes first, and the resulting set of feasible returns follows. The other questions address risk tolerance.

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Which of the following statements is NOT consistent with the assumption that individuals are risk averse with their investment portfolios?

A) Higher betas are associated with higher expected returns.

B) There is a positive relationship between expected returns and expected risk.

C) Many individuals purchase lottery tickets.

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Investors are risk averse. Given a choice between two assets with equal rates of return, the investor will always select the asset with the lowest level of risk. This means that there is a positive relationship between expected returns (ER) and expected risk and the risk return line (capital market line [CML] and security market line [SML]) is upward sweeping. However, investors can be risk averse in one area and not others, as evidenced by their purchase of lottery tickets.

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All of the following affect an investor’s risk tolerance EXCEPT:

A) family situation.

B) years of experience with investing in the markets.

C) tax bracket.

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Tax concerns play an important role in investment planning. However, these constitute an investment constraint, not an investment objective (i.e. risk tolerance).

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Which of the following factors is least likely to affect an investor’s risk tolerance?

A) Number of dependent family members.

B) Level of inflation in the economy.

C) Level of insurance coverage.

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The level of inflation in the economy should be considered in determining the return objective. Risk tolerance is a function of the investor's psychological makeup and the investor's personal factors such as age, family situation, existing wealth, insurence coverage, current cash reserves and income.

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Which of the following statements about risk is NOT correct? Generally, greater:

A) spending needs allows for greater risk.

B) insurance coverage allows for greater risk.

C) existing wealth allows for greater risk.

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Greater spending needs usually allow for lower risk because there is a definite need to ensure that the return may adequately fund the spending needs (a “fixed” cost).