Reading 15: Managing Individual ....tor Portfolios －LOS j investor, ability, discuss, return, impact

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CFA Institute Area 3-5, 7, 12, 14-18: Portfolio Management
Session 4: Private Wealth Management
Reading 15: Managing Individual Investor Portfolios
LOS j: Explain how to set risk and return objectives for individual investor portfolios and discuss the impact that ability and willingness to take risk have on risk tolerance.

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

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

C) ability to take risk is connected with secondary goals and objectives.

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

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Answer and Explanation

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.

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The ability to take risk is best judged by:

A) the time horizon of long term objectives.

B) the time horizon of only short term objectives.

C) not connecting time horizon with objectives.

D) the time horizon of both short- and long-term objectives.

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Answer and Explanation

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

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The willingness to take risk is best judged by the:

A) financial profile of the investor.

B) subjective nature of the perspective investments.

C) psychological profile of the investor.

D) objective nature of perspective investments.

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Answer and Explanation

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

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

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

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

C) Expected inflation is not important when an individual client is faced with substantial income requirements.

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

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Answer and Explanation

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.

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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 Szarens fathers estate. In addition to their income and their inheritance, the Kreuzs have accumulated the following assets:

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

The Kreuzs 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 Kreuzs express concern about having enough assets for a comfortable retirement. The Kreuzs 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 Kreuzs. 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 Kreuzs?

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

D) Above Average Below Average Above Average

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Answer and Explanation

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.

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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 clients risk tolerance and return objective separately from one another.
Procedure 2:	Focus on the investors required returns only, as desired returns are not important when drafting the IPS.

With regard to the procedures Paskiet has proposed:

A) both Procedures 1 and 2 are correct.

B) Procedure 1 is correct, but Procedure 2 is incorrect.

C) both Procedures 1 and 2 are incorrect.

D) Procedure 1 is incorrect, but Procedure 2 is correct.

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Answer and Explanation

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.

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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 daughters college education, which will begin in 15 years. Piaseckis 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 Piaseckis investment manager?

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

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

C) Invest in the diversified stock portfolio since it is the only way to achieve Piaseckis goals.

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

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Answer and Explanation

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.