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Portfolio Management and Wealth Planning【Reading 10】

Jennifer Moore has worked in a governmental position (administrative assistant) since graduating from high school. She loves her job because she is very good at following her bosses’ orders. At office functions, many of her colleagues ranted and raved about the quality of her baked goods. Some even suggested that they tasted so good that she should quit her job and sell baked goods. Moore is 50 years old and never paid attention to the suggestions of her colleagues. She plans on retiring from the government in three years.Based on her personality type, what type of investor is Moore?
A)
Methodical.
B)
Cautious.
C)
Individualist.



Moore appears to be a cautious investor. She appears unwilling/unsure about making decisions on her own (following bosses’ orders), which goes against the individualist and methodical investor.

Jennifer Moore recently came into a seven-figure inheritance from a long-lost uncle. Which of the following statements about Moore is most accurate?
A)
Since she didn't count on the inheritance, she will be willing to take on substantial investment risks.
B)
She will be willing to take an active role in the investment process.
C)
Moore has little to no familiarity with risk taking and will tend to be more cautious in her investment approach.



Wealth acquired through inheritance could indicate an individual who has less familiarity with risk taking activity. Given her other personality traits, it appears unlikely that Moore will want to take an active role in the investment process and/or knowledge. She enjoys taking orders.

Jim Thamen, CFA, recently received an assignment from his supervisor Andy Stone, CFA, to prepare a proposal for managing Ellen and Joe Swathman’s investment portfolio. Ellen, 62, and Joe, 65, recently inherited $2,500,000 from Ellen’s eccentric uncle, Daniel, and wish to invest their money wisely. The Swathmans have two grown children, Marcus, 30, and Sue, 27, who are financially independent from their parents. Although both Marcus and Sue are married, the Swathmans do not have any grandchildren.
For the past 20 years, Ellen has worked as a legal secretary for a regional law practice that specializes in professional malpractice, product liability, and worker’s compensation litigation. Joe is nearing retirement age at the local rock quarry he co-founded with a high school classmate almost 40 years ago. Although the rock quarry has not provided the Swathmans with a large amount of excess discretionary income, they have been able to provide themselves and their children a comfortable living. Joe and his partner Ed Small have executed a buy-sell agreement and maintain life insurance to fund a buy-out in the event of the untimely death of either. Although Ellen is planning to retire within 9 to 12 months, Ed wants to continue working at the quarry for a few more years.
The Swathmans are in relatively good health, have adequate health insurance, property and casualty, disability, liability, and life insurance. All consumer debts have been paid. They plan to spend approximately $200,000 over the next year renovating their home in preparation for retirement.
Thamen recorded the following statements made by Joe Swathman in a recent meeting:

1. “Ellen and I do not consider ourselves wealthy by any measure. Although the inheritance doubles our net worth, I know plenty of others with substantially greater retirement accounts. Besides, we have a quite a bit tied up in the business. On top of that, we will probably live another 25 years. So I think we are average risk-takers.”
2. “Ellen’s work has made her sensitive to potential property and casualty or liability losses. She leaves the investment decisions up to me, but says that we should be careful.”
3. “I had a great return with Netshopper stock and sold it too early. I bought it at $1.25. Last year when they announced a distribution deal with Nike the stock jumped to $8.75 so I sold. It’s still going strong, as both their sales model and management team are winners. Yesterday, I checked and it closed at $26.00.”
4. “I've been following a stock called Computrol which was projected to hit $42.50. New information came out from the company with predictions it should hit $85.00 but analysts predicted it will only hit $65.”

A week later, Thamen is trying to determine the appropriate dynamic asset allocation strategy for the Swathman portfolio given the economic outlook, capital market conditions, and the Swathman’s risk and return objectives. He consults his supervisor, Andy Stone, to discuss it.
Thamen begins by stating that “a buy and hold strategy outperforms a constant mix strategy in a trending market and underperforms the constant proportion portfolio insurance strategy (CPPI) in a flat, but oscillating market."
Stone replies: “I agree that a buy and hold strategy outperforms a constant mix strategy in a trending market but it also outperforms the CPPI strategy in a flat, but oscillating market."
In formulating an investment policy statement for the Swathmans, Thamen decides to develop a brief situational profile for his clients. Which of the following best represents the situational risk profile for the Swathmans?
A)
With respect to source of wealth, measure of wealth, and age, Joe Swathman's statements and the additional supporting information indicate below-average to average risk tolerance.
B)
With respect to source of wealth, measure of wealth, and age, Joe Swathman's statements and the additional supporting information indicate an overall average risk tolerance.
C)
The Swathman’s substantial net worth, the financial independence of their children, and the fact that the Swathman’s have no grandchildren to provide for in the future indicate an above-average to aggressive risk tolerance.


The size of their assets in the context of their age (time horizon), suggests the Swathman’s are unlikely to exhaust their savings during retirement. Thus, their financial situation indicates an above-average ability to incur risk. In contrast, Joe's entrepreneurial background (increased risk tolerance), statement about them being of average risk tolerance, his statement about Ellen saying they should be careful (below average risk tolerance), adequate insurance, and no debt indicates they manage their finances in a responsible manner. Hence their statements and background reflect an average to some what below-average willingness to take risk leaning more towards average. Overall their risk tolerance would be average based on their average willingness to take risk. On the exam you would not want to give a range of risk tolerances but instead state a single level of risk tolerance. For example state something like:
  • Ability to tolerate risk is above average
  • Willingness is average
  • Overall risk tolerance is average

In this particular case of the Swathman's their asset base is not large enough to average the two risk tolerances of ability and willingness together and recommend counseling to reconcile the two. You would instead defer to the lower level of risk tolerance which is their willingness. (Study Session 4, LOS 10.a)

Thamen understands that behavioral finance topics are becoming more important when attempting to better understand the relationship between portfolio manager and client. Which of the following behavioral investor traits were exhibited in Swathman's statements 1-4?
A)
Frame dependence and familiarity.
B)
Representativeness and loss aversion.
C)
Regret and anchoring.



Only statements 3 and 4 describe behavior investor traits. Statement 3 is describing regret where the feeling in hindsight is associated with making a bad decision. Statement 4 is describing anchoring which is the inability to fully incorporate the impact of new information on projections. (Study Session 3, LOS 8.b)

Thamen starts formulating the risk tolerance portion of the investment policy statement. He knows it is important to consider both the willingness and ability to take risk. Which of the following generally has the most impact on an individual’s ability to take risk?
A)
Portfolio size and time horizon.
B)
Liquidity requirements and tax considerations.
C)
Liquidity requirements and portfolio size.



The ability to incur risk is determined by the size of an investor’s portfolio relative to his goals, the time horizon, the importance of the investment goals and the amount of volatility the portfolio can sustain without jeopardizing the goals. Other constraints (taxes, liquidity needs, etc.) may impact both the ability and willingness of and individual to take risk but are not generally considered to be as important as time horizon and portfolio size. (Study Session 4, LOS 10.j)

Regarding the comments by Thamen and Stone about the different dynamic asset allocation strategies:
A)
Stone is correct on Buy and Hold, but incorrect on CPPI; Thamen is correct on both Buy and Hold and CPPI.
B)
Stone is incorrect on both Buy and Hold and CPPI; Thamen is incorrect on Buy and Hold and correct on CPPI.
C)
Stone is correct on both Buy and Hold and CPPI; Thamen is correct on Buy and Hold and incorrect on CPPI.



Stone's statement is correct. The Buy and Hold strategy outperforms a Constant Mix strategy in a trending market and outperforms the CPPI strategy in a flat but oscillating market. Thamen was right about Buy and Hold but wrong on CPPI.
The Constant Mix strategy outperforms a comparable Buy and Hold strategy, which, in turn, outperforms a CPPI strategy in a flat but oscillating market.
The CPPI strategy outperforms a comparable Buy and Hold strategy, which, in turn, outperforms a Constant Mix strategy in trending markets. (Study Session 16, LOS 40.h)


Thamen wants to incorporate the information ratio in the portfolio management process. Which of the following statements best describes the information ratio?
A)
The information ratio uses tracking error in the numerator of the equation which represents the standard deviation of monthly alphas.
B)
The information ratio shows the relationship between the manager's alpha and the standard deviation of alpha.
C)
The lower the information ratio, the more likely it is that a manager's performance is the result of skill rather than luck.



The information ratio is used to determine if a manager's alpha is a result of mere chance, or the manager's skill. It shows the relationship between the manager's alpha and the standard deviation of alpha (tracking error): information ratio = alpha / tracking error. (Study Session 17, LOS 41.p)

Thamen has been reading about the benefits of using Monte Carlo approaches in retirement planning. Which of the following is NOT a correct statement with regard to the benefits of using a Monte Carlo approach?
A)
Monte Carlo forecasting techniques result in greater reliability than deterministic techniques.
B)
Monte Carlo techniques often better represent trade-offs between short term risks and long-term goals.
C)
Probabilistic forecasts are often better than point estimates in financial markets.



The results of Monte Carlo techniques are only as good as the inputs used. A weakness of Monte Carlo simulations is the need to pre-specify the distribution of the variables used or rely on historical distributions. (Study Session 4, LOS 10.n)

TOP

Which of the following is NOT determined using situational profiling? Investor:
A)
behavior.
B)
biases.
C)
philosophy.



Situational profiling does not determine investor behavior, but represents an analysis of behavior in determining preferences and biases, as well as philosophy.

TOP

Sheryl Rubenstein is a stunt double in Hollywood. Her studio took out a life insurance policy on her. What method of handling risk is her studio using? Risk:
A)
transference.
B)
reduction.
C)
avoidance.



The studio is using a risk transference method by purchasing life insurance. That way, they will not bear the risk of lost income if she dies while performing a stunt. Instead, they will receive the insurance proceeds.

TOP

Which of the following statements regarding situational profiling is least accurate?
A)
Situational profiling considers an individual's preferences, economic resources, goals, and desires.
B)
With situational profiling, the source of an investor's wealth is considered an indicator of the investor's risk tolerance.
C)
When properly used, situational profiling will provide a great degree of insight into an investor's preferences, economic situation, goals, and desires.



Due to the extensive number of possible individual situations, situational profiling must be applied cautiously. It should be applied as only an initial step in developing an understanding of an individual’s preferences, economic situation, goals, and desires.

TOP

An investor’s source of wealth is often considered important in determining attitudes towards risk taking. Which source of wealth is considered commensurate with greater risk tolerant profiles?
A)
Passively acquired sources of wealth.
B)
Actively acquired sources of wealth.
C)
Inherited sources of wealth.



Actively acquired sources of wealth are often associated with entrepreneurial or other risk taking activities. Individuals with actively acquired sources of wealth are often considered to have taken risk and know and understand what it means to take risks in order to create wealth.

TOP

Situational profiling often uses measures of wealth in determining investor risk preferences. Which of the following is the best definition for measure of wealth within a situational profiling context? The:
A)
absolute amount of wealth held.
B)
amount of wealth held in the stock market.
C)
perceived amount of wealth held.



The amount of wealth important to an investor in a situational profile is the amount of wealth perceived as large or small by the investor. If the investor perceives his amount of wealth to be large, he may be more tolerant of risk taking activities. If the amount of wealth is perceived to be small, the investor may be less tolerant of risk taking activities.

TOP

Andirah Wang is a new client of Willowtree Investment Advisors (Willowtree). As part of her initial meeting with her advisor, Anita Reinholt, CFA, Wang completed a questionnaire designed to profile her personality type. The results indicated that she is a person who has a conservative investing nature, but is confident in her own ability to research investment options in a careful, systematic manner.
Reinholt believes in modern portfolio theory (MPT), but after years of experience knows that an individual’s investment preferences and decisions are not always congruent with MPT. She has become increasingly interested in the tenets of behavioral finance theory in hopes that it will help her understand each client’s motivations and biases. When meeting with prospects or clients, she is careful to document comments and observations relative to the portfolio management process. Reinholt recorded the following statements made by Wang during the initial consultation:
  • "I use the "basket" theory of investing - I don't want to put all my assets in one place so I'll give you a try with about 20% of my investment portfolio - that way I can see how you do relative to my other advisors."
  • “I have been following Pharmitrol, a local company listed on NASDAQ. Several of my neighbors have production jobs there and are really optimistic about the firm’s prospects. Of course they’re not in management, but I think they should be able to sense what’s going on. I have a significant position now at $3.50 per share and expect to triple my investment soon.”

Reinholt is considering the appropriate risk and return objectives for Wang’s account. Wang said that she would like a “moderately aggressive” portfolio. Upon reviewing her balance sheet, however, Reinholt notes that Wang already has a significant allocation to a few high-risk securities. In addition she has some other illiquid and personal use assets, such as her residence, a time share condominium, and an interest in a local miniature golf course. Relative to her stated spending and retirement goals, her total net worth appears to not be adequate to meet those goals.The analysis of Wang’s personality questionnaire indicates that she most likely is a:
A)
individualistic investor.
B)
methodical investor.
C)
cautious investor.



Wang’s systematic research, confidence in her own ability and conservative nature place her in the general category of methodical investors. Note that cautious investors are the most risk averse and that individualistic investors tend to be more aggressive. (Study Session 4, LOS 10.e)

Statement 1 by Wang is reflective of which of the following basic principles of the behavioral finance investment framework?
A)
Loss aversion.
B)
Asset integration.
C)
Asset segregation.



Asset segregation is the tendency to evaluate a manager or investment in isolation instead of measuring the impact on the overall portfolio. (Study Session 4, LOS 10.b)

The statement by Wang about Pharmitrol is most reflective of which of the following behavioral tendencies?
A)
Familiarity.
B)
Overconfidence.
C)
Anchoring.



Wang is overconfident about the information she has about Pharmitrol’s prospects and is making an unjustified bet. She doesn’t realize she doesn’t have all the information necessary to form an unbiased projection. Anchoring refers to the inability to fully incorporate (adjust) the impact of new information on projections. Familiarity is when investors invest in securities they are familiar with such as their own company’s stock or domestic versus international equities. (Study Session 3, LOS 9.b)

Which of the following is NOT one of the behavioral finance traits that leads to market inefficiency? Investors:
A)
all have the same information and interpret it the same way.
B)
think a well run company will be a good investment.
C)
are overconfident in their ability to interpret information and predict performance.



Market efficiency assumes all investors have the same information, interpret it the same way, and make the same forecasts.  Some behavioral finance traits can lead to market inefficiencies such as representativeness, anchoring-and-adjustment, loss aversion, frame dependence, and overconfidence. Representativeness can take many forms and can be characterized as any time an investor bases expectations for the future on some past characteristic. Anchoring-and-adjustment refers to the inability to fully incorporate the impact of new information on previous projections. Loss aversion can lead to investors holding on to a losing stock too long or to increased risk seeking behavior to recover from a loss. Frame dependence refers to investors' tendency to frame their tolerance on the current direction of the market or in the context of the information received rather than on its own merits. Overconfidence is when people place too much confidence in their ability to predict resulting in unjustified bets. (Study Session 4, LOS 10.c)

For understanding an individual’s preferences, goals and desires, situational profiling:
A)
places individuals into categories according to sources of wealth and level of risk aversion.
B)
is superior to psychological profiling.
C)
places individuals into categories according to stage of life and economic circumstances.



Situational profiling can enhance an advisor’s understanding of an investor’s preferences, goals, and desires by categorizing individuals according to sources and measures of wealth as well as stage of life. (Study Session 4, LOS 10.b)

Which of the following statements about Wang's ability and willingess to take on risk is most accurate? Wang’s
A)
willingness to take risk is more important than her ability to take risk.
B)
ability to take risk is determined by her time horizon and portfolio size.
C)
willingness and ability to take risk are incongruent therefore Rineholt should defer to Wang’s desire for a moderately aggressive portfolio.



Willingness to take on risk is the investor's own personal view of their level of risk aversion. Ability to take on risk is determined by several factors such as length of lifespan and portfolio size relative to goals. It is usually best to defer to a person's willingness to take on risk unless a conflict arises and their willingness is greater than their ability. Under the current circumstances, it appears that Wang’s stated risk tolerance is not only incongruent with her economic status, but is also in conflict with her personality profile. Rinehart should meet with Wang for education purposes and to explore the inconsistencies. (Study Session 4, LOS 10.j)

TOP

Which of the following is a reason why psychological profiling is important for understanding individual investor behavior? Investors:
A)
are assumed to only select portfolios that maximize a return for a given level of risk.
B)
focus on individual asset risk/return characteristics as well as how the individual asset interacts with other assets in the portfolio.
C)
are loss averse.



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).

TOP

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)
Not enough information to tell.
B)
Low-to-moderate.
C)
Moderate-to-high.



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.

TOP

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