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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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.

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Which of the following statements is most correct?

A) If an investor achieves relative performance objectives, they will also be assured of meeting absolute performance objectives.

B) If an investor achieves absolute performance objectives, they will also be assured of meeting relative performance objectives.

C) An investor can achieve relative performance objectives, and still fail to achieve absolute performance objectives.

D) Most lifestyle objectives are best framed in terms of relative performance objectives.

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Answer and Explanation

An investor can achieve relative performance objectives, and still fail to achieve absolute performance objectives. For example, a benchmark may have a negative return during a given period. Exceeding the benchmark is no assurance that absolute performance objectives will be realized. Conversely, failing to match a relative objective does not insure that an absolute objective will not be met.

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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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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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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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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.