kim226

Sam and Ellen Smithson have both recently retired after numerous years of working as a heart surgeon and pediatrician, respectively. The Smithsons were not able to have children, so they devoted their lives to helping others through their professional and charitable activities. Sam was involved in the local “Pantry Pass,” an organization that gathered food items for distribution to the needy. Ellen was involved in her local “Housing for the Homeless,” chapter. Both served their respective organizations in direct service and board member capacities.
The Smithsons’s professional activities generated high incomes that were beyond living expenses, which could easily be described as comfortably frugal. Over the years, a tax deferred retirement savings account in the amount of $4,000,000 has been accumulated. During discussions with Marcus Medley, CFA, Sam and Ellen mentioned the following:

• Our living expenses are minor and are estimated to be no greater than $150,000 per year. As a result, we consider our retirement portfolio to be large both in absolute and relative terms
• We are both in good health and have at least another 20 to 25 years of life expectancy. We do not foresee any major medical expenses, either chronic or acute, over the horizon.
• We have no debts and wish not to undertake decisions that would require us to borrow.
• After we die, we would like to leave the remainder of our portfolio equally to the charities with which we have been involved over all these years. One of our objectives is to maximize those funds transferred.
• Neither one of us has a high tolerance for risk and, for the most part, our retirement savings have been in low-risk type investment vehicles. Our investment portfolio decisions have been made in congruence with our feelings of enhancing the opportunities available to our fellow man.
• When we have invested in equity-type securities, we have focused investing in socially responsible funds. Firms that sell tobacco, firearms, alcohol, or have been cited by the EPA for environmental damage are not allowed in our portfolio.

Medley has taken the Smithsons’ personal statements, as well as economic activity forecasts, and is attempting to formulate an investment policy statement, as well as recommend some general asset allocation guidelines.
Medley first decides to classify the Smithsons along general investment personality typing guidelines. Which of the following personality types best describes the Smithsons?

A) Cautious.

B) Methodical.

C) Individualist.

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The Smithsons have indicated they are somewhat risk averse. Additionally, statements referring to investment decisions being made parallel with feelings, and not necessarily those based on thinking, are congruent with a cautious personality type.

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In formulating the risk objective statement, Medley must formalize the Smithsons according to their ability and willingness to take on risk. Regarding the Smithsons’ risk profile, Medley appears able to make the direct statement that the Smithsons are:

A) able and willing to take above average risk.

B) able to take above average risk, but are only willing to take below average risk.

C) only able to take below average risk, but are willing to take above average risk.

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Given the data regarding the Smithsons’ situation, it appears that they are able to take above average risks (large absolute and relative sized portfolio), but only willing to take below average risks (“neither of us has a high tolerance for risk”).

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One additional factor Medley believes important is the Smithsons’ stage of life. Which of the following best represents the Smithsons’ stage of life?

A) Early.

B) Latter.

C) Mid.

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The Smithsons are obviously in the latter stage of their life cycle. Even though both appear to have a long life left, they are retired and are looking at how their legacy will be remembered after they die.

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According to the Smithsons’ risk profile created by Medley, a general asset allocation that would fit well with their objectives is:

A) an aggressive growth asset allocation so that the largest amount of funds will be left to their charities.

B) a portfolio heavily weighted toward risk-free securities to minimize possibilities of making inappropriate investments.

C) an asset allocation that focuses on generating a conservative total return to meet not only minimal current needs, but also the objective of maximizing the funds transfer to the charities.

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An asset allocation that focuses on total return would appear to best meet the Smithsons’ objectives given the apparent disconnect between ability and willingness to take risk. The total return approach provides an appropriate balance between meeting their retirement needs and providing for the charities.

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Which of the following investments would NOT be appropriate in the Smithson's portfolio?

A) Options.

B) Commodities.

C) Municipal bonds.

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Since their retirement savings account is tax deferred it would not be appropriate to put a tax free investment such as a municipal bond into an already tax deferred account. Municipal bonds are most effective in the taxable accounts of higher income earners. The other investment choices may be appropriate in the portfolio if added in the appropriate proportions and used to diversify the portfolio reducing the overall risk of the portfolio.

kim226

Which of the following statements regarding the investment policy statement is least accurate? An individual’s investment policy statement:

A) is exactly the same as that of an institution's.

B) differs from an institution's in that taxes play a more prominent role.

C) differs from an institution's in that time horizon plays a more prominent role.

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An individual’s investment policy statement differs from an institution’s in that time horizon, taxes, and unique circumstances play a more prominent role. The overall process is the same.

kim226

Which of the following represents the process involved in creating an investment policy statement?

A) Evaluate objectives, capital market expectations, and investment strategies.

B) Evaluate objectives and constraints and combine them with capital market expectations.

C) Determine constraints and formulate investment strategies.

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Objectives and constraints are evaluated, and when they are combined with capital market expectations, the investment policy statement is created.

kim226

Bill Litner, CFA has been hired by Terrific Tires, Inc. (TTI) to counsel TTI’s employees concerning their investments. Jill Fisher is one of the employees and she approaches Litner to help her manage her personal finances. Fisher is 36, and earns $30,000 per year from her job at TTI. She rents an apartment, has about $5,000 in savings, and $3,000 in credit card debt. She is divorced with a 12-year old child and does not receive alimony or child support. A previous analysis performed by a financial expert from the company had predicted that Fisher’s defined benefit pension plan would be able to support her in her retirement at her current standard of living. TTI’s medical coverage is very good and will cover her in her retirement. Although Fisher has no other source of income, she recently inherited approximately $2 million in cash from a distant relative, and that is the reason she has approached Litner. After an initial consultation, Fisher asks Litner to be her investment advisor. As a first step, Litner attempts to assess Fisher’s personality type with the use of a questionnaire. The questionnaire indicates that she is conservative in that she will want to know with some certainty the lower limit of the value of her portfolio in the future. Also, she wants to be informed about every aspect of the investment process, e.g., get detailed information concerning every investment recommendation that Litner makes for her portfolio before approving it. Part of the questionnaire attempts to determine how open Fisher is to changes. The questionnaire’s results indicate that she is willing to adjust and sell positions readily, even at a loss, if new information indicates a change is needed. Litner intends to use the information from the questionnaire to compose an investment policy statement (IPS). He feels that he should compose the outline of the statement in a consultation with Fisher. When Litner asks Fisher to meet with him to compose an IPS, Fisher tells Litner that she does not see the need for such a statement. She says that she thinks that Litner’s credentials are excellent. Furthermore, since she has indicated that she intends to review in depth all of Litner‘s recommendations, having such a statement is unnecessary. Litner attempts to gather the information he needs through a series of informal conversations. During one conversation, he gleans from Fisher her returns expectations. During a later conversation, he questions her concerning her attitudes towards risk and other tastes and preferences. Fisher asks Litner to send her information on Litner’s first recommendation for her $2 million portfolio. She asks that he send to her such information one at a time for her to review so she can build her portfolio steadily one investment at a time. Fisher tells Litner at the outset that she wants to avoid frequent rebalancing and turnover because she has heard the costs and tax consequences of rebalancing and turnover can have a significant and negative impact on the returns of the portfolio. Litner’s insistence on an investment policy statement (IPS) is:

A) justified because it is beneficial for both Fisher and Litner.

B) not justified, and it should be considered optional.

C) justified because it is beneficial for Litner but not necessarily for Fisher.

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An IPS benefits both the client and the advisor. For example, it benefits the client because it sets guidelines for every recommendation by the advisor and it benefit’s the advisor because it protects the advisor in cases where investments do not perform exactly as expected. (Study Session 4, LOS 10.h)

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Given Fisher’s age and her source of wealth, Fisher’s familiarity with risk taking is:

A) most likely minimal, and she should be willing to accept a lower than average level of risk.

B) most likely minimal, but she should be willing to accept a higher than average level of risk.

C) probably high given her lifestyle, and she should be willing to accept a higher than average level of risk.

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Persons who acquire their wealth through a windfall tend to have minimal familiarity with risk taking. Given that her age is less than 40, she should be able to accept a higher than average level of risk. (Study Session 4, LOS 10.a)

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The use of a questionnaire to assess Litner’s personality type is:

A) a standard approach, and Fisher appears to be a methodical investor.

B) a standard approach, and Fisher appears to be a spontaneous investor.

C) a standard approach, and Fisher appears to be an anchoring investor.

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Such a questionnaire is widely used for just his purpose. Given that Fisher wants to learn about each investment before she invests indicates she is methodical. (Study Session 4, LOS 10.f)

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Fisher’s desire to create her portfolio one asset at a time is:

A) not unusual and is indicative of the role of investor psychology in investment choices.

B) very unusual, but it is an acceptable method to create a portfolio for an individual investor, and Litner should follow Fisher‘s preferences.

C) very unusual, and indicates that Litner should not take Fisher on as a client.

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Fisher’s desire to compose a portfolio one position at a time is fairly typical of unsophisticated investors. Litner should try to convince Fisher of the benefits of taking a portfolio approach. (Study Session 4, LOS 10.d)

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Fisher’s fear of the costs associated with rebalancing and turnover are:

A) justified for rebalancing but not for turnover.

B) not justified for rebalancing but are justified for turnover.

C) justified for both rebalancing and turnover.

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Rebalancing and turnover can both increase transactions costs and can have unfavorable tax consequences. (Study Session 4, LOS 11.f)

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Litner’s attempt to gather information for the IPS through a series of conversations, as described, is:

A) one of many appropriate ways for gathering information.

B) recommended because it allows Litner to assess the accuracy of the information for consistency.

C) not recommended and deemed inappropriate.

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It is not appropriate because planning return expectations should take place concurrently with risk tolerance discussions. (Study Session 4, LOS 10.h)

kim226

Larry Smith, CFA, is the new equity portfolio manager for a socially responsible mutual fund. The investment policy statement stipulates which stocks do not meet the fund’s definition of socially responsible. Because Smith was new to the fund, he did not personally agree to the stocks that were forbidden. Subsequently, he included a stock into the portfolio that was on the restricted list. Which of the following statements is least accurate?

A) Smith did not violate the investment policy statement.

B) Smith was responsible for reading and understanding the investment policy statement prior to stock selection.

C) Smith is to be held responsible for the investment policy statement even though it was written before he was employed at the fund.

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Smith is in clear violation of the fund’s investment policy statement. Just because he is new to the fund, does not exempt him from following the statement. Most investment policy statements contain a stated review process that provides direction for dispute resolution.

kim226

An investment policy statement benefits investment advisors because it provides:

A) guaranteed legal protection against errors in omission lawsuits.

B) an understanding of the advisory relationship between manager and client.

C) guidelines for capital market expectation formations.

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The investment policy statement provides an understanding of the relationship between manager and client. The investment policy statement does not provide guaranteed legal protection or how to form capital market expectations.

kim226

An investment policy statement does NOT provide which of the following?

A) Guaranteed investment returns.

B) Long-term investment decision making guidelines.

C) Weighting ranges for asset allocation.

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An investment policy statement does not provide guaranteed investment results.

kim226

Clients can benefit from an investment policy statement which:

A) provides for legal recourse due to portfolio underperformance.

B) dictates how to spend extra liquidity.

C) provides long-term investment discipline deterring short-term knee-jerk portfolio adjustments.

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The purpose of an investment policy statement is to provide long-term discipline in investment decision making. The investment policy statement protects against short-term portfolio adjustments resulting from investor panic or overconfidence.

kim226

Which of the following statements concerning an investor’s policy statement is least accurate? The investment policy statement:

A) should represent the long-term objectives of the investor.

B) provides guidance to the investment advisor regarding issues of appropriateness of decisions.

C) determines the client's ability and willingness to take risk.

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The investment policy statement does not determine the client’s ability and willingness to take risk. These are a function of the client’s situation and personality type. The IPS should, however, discuss the client’s willingness and ability to take risk.

kim226

Which of the following personality types applies to investors who make investment decisions based on facts as opposed to their feelings or intuitions?

A) Methodical and cautious.

B) Spontaneous and methodical.

C) Methodical and individualist.

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Methodical investors research markets, industries, and firms for potential investments and are constantly on a mission to improve their analytical decision-making skills. Individualists also research their investment opportunities and exhibit independent thought when making investment decisions. Individualists are very confident, and this makes them capable of questioning inconsistencies in either recommendations or conclusions made by others. Individualist investor types tend to be less risk averse than methodical investors.