prashantsahni

Kent Andling is 55 years old and recently sold his high tech manufacturing company, which was started in his father’s basement 35 years ago. Andling’s two children are grown and have been featured in recent entrepreneur magazine articles as up and coming entrepreneurs. How would Andling be classified given this brief profile?

A) Not enough information to tell.

B) Low-to-moderate risk tolerant.

C) Moderate-to-high risk tolerant.

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Although Andling is approaching the latter stage of life, his participation as an entrepreneur of a high-tech manufacturing firm indicates knowledge of risk-taking activities. Apparently, he has brought up his children to understand risk-taking activities, too. These factors indicate a moderate-to-high risk tolerant profile.

prashantsahni

Dan Newsmith is 35 and was recently promoted to regional sales manager of a national trading company. Newsmith has no credit card debt, he does not have an automobile loan, and his home is mortgage free. Newsmith’s salary and bonus more than adequately cover living expenses. Given this brief profile, classify Newsmith’s ability to tolerate risk when investing excess funds.

A) Low-to-moderate risk tolerance.

B) Moderate-to-high risk tolerance.

C) Not enough information to tell.

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Newsmith’s stage of life (young age) and low requirement for current liquidity (no debts, living expenses covered) indicate a situational profile to tolerate moderate-to-high risk.

prashantsahni

In creating an investment policy statement, a portfolio manager needs to be aware that an investor’s psychological profile may impact:

A) neither the investor’s risk tolerance nor their return objective.

B) the investor’s risk tolerance and return objective.

C) the investor’s risk tolerance only.

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Psychological profiling is important for understanding individual investor behavior because defense mechanisms of the brain often cause investors to violate standard finance assumptions (MPT), resulting in irrational decisions. These psychological tendencies can impact client preferences, goals and constraints. When constructing an investment policy statement, these psychological preferences can have a direct impact on a client’s willingness to take risk as well as their desired return.

prashantsahni

Amy Tillman and Josh Northrup are portfolio managers for Parquet Asset Management. Tillman and Northrup are discussing the process their firm uses to identify an individual investor’s objectives and constraints, and ultimately construct an investment policy statement. Tillman makes the following statements to Northrup during the course of their conversation:

Statement 1:	Since investors tend to exhibit irrational, psychological characteristics, the investor should be educated so that these characteristics are put aside and rational expectations can be the sole determinant of the investor’s risk and return objectives.
Statement 2:	Investors that exhibit the characteristic of asset segregation may tend to take on more risk than necessary in their portfolios.

With regard to Tillman’s statements:

Statement 1

Statement 2

A) Correct Incorrect

B) Correct Correct

C) Incorrect Correct

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Psychological/behavioral patterns can have a significant influence on an investor’s decision making process. Statement 1 is incorrect – the role of a portfolio manager is not to eliminate the effect of these psychological patterns on decision making, but to know and understand the investor’s situation, and use these psychological characteristics when discussing risk and return objectives with the client. The client may need education, but the psychological characteristics a client has should be a key consideration when setting risk and return objectives. Statement 2 is correct. Asset segregation refers to focusing on individual assets instead of evaluating the asset’s impact on the portfolio. Asset segregation tends to lead to the investor taking on more risk than is necessary in their portfolio – the investor may dismiss a particular asset because “it is too risky” however, in a portfolio context, the asset would actually reduce the risk of the portfolio as a whole.

prashantsahni

When investors choose riskier investments over less risky choices in the domain of losses, they exhibit which of the following characteristics?

A) Risk aversion.

B) Asset segregation.

C) Loss aversion.

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When investors chose larger uncertain losses over smaller losses that are certain, they exhibit loss averse behavior.