kim226

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

With regard to the procedures Paskiet has proposed:

Procedure 1

Procedure 2

A) Incorrect Correct

B) Correct Incorrect

C) Incorrect Incorrect

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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.

kim226

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 Szaren’s father’s estate. In addition to their income and their inheritance, the Kreuz’s have accumulated the following assets:

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

The Kreuz’s 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 Kreuz’s express concern about having enough assets for a comfortable retirement. The Kreuz’s 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 Kreuz’s. 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 Kreuz’s?

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

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The Kreuz’s 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 portfolio’s ability to meet investor goals.

kim226

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 daughter’s college education, which will begin in 15 years. Piasecki’s 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 Piasecki’s investment manager?

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

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

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

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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 client’s willingness to take risk unless doing so would jeopardize the portfolio’s ability to meet the investor’s 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 two 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.

kim226

The willingness to take risk is best judged by the:

A) subjective nature of the perspective investments.

B) psychological profile of the investor.

C) financial profile of the investor.

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

kim226

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

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

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

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

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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.

kim226

The ability to take risk is best judged by:

A) the time horizon of only short term objectives.

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

C) the time horizon of long term objectives.

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

kim226

Although legal and regulatory constraints do not usually impact an individual investor’s policy statement, attention must often be paid between two parties of personal trusts. Which parties exhibit the greatest tension in setting investment policy for a personal trust?

A) Grantor and remaindermen.

B) Income beneficiary and remaindermen.

C) Income beneficiary and the trust officer.

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A creative tension exists between the income beneficiary and remaindermen listed in a personal trust. Income beneficiaries would like to have as much current income from the trust as possible. Remaindermen wish to have as large of a portfolio passed to them after the income beneficiary dies. The conflict between current income and longer-term portfolio growth is a situation that must be addressed in formulating investment policy for a personal trust.

kim226

Which class of liquidity constraints is usually NOT considered a factor when formulating an individual’s investment policy statement?

A) Negative liquidity events.

B) Cash carried on the person.

C) Ongoing expenses.

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The amount of cash an investor carries with them should not impact the investment policy statement. The primary liquidity constraints impacting the long-term policy statement are those cash outflows required in meeting ongoing expenses and negative liquidity events.

kim226

Vivian Collins is a client of ESP Financial Advisors. She presents her situation as follows: Collins is currently a divorced mother to a 5-year-old daughter, Daija. She is 35 years old. She has worked at her current job with the government for the last 13 years, and assumes that she will remain there until retirement and collect her pension. Collins wants to be able to send Daija to the college of her choice. Collins expects her daughter to eventually marry and have children. She would love to be able to leave something to these future grandchildren. How many time horizons does Collins have?

A) 3.

B) 4.

C) 5.

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Collins has 4 distinct time horizons. The first is now until the time that Daija enrolls in college. The second is supporting Daija's college education. The third is her remaining years before retirement and after supporting Daija through college. The fourth is retirement. In retirement if a goal is to leave some assets to her grandchildren then the portfolio would need to be managed with that in mind.

kim226

With respect to the constraints portion of an investor’s investment policy statement, issues relating to on-going expenses, emergency reserves, alterations in on-going expenses, and transactions costs are all examples of:

A) time horizon issues.

B) unique circumstances.

C) liquidity issues.

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The issues listed in the stem of the question are concerned with the investor’s liquidity requirement.