Chapter 7

Question 1

What is your primary role as a wealth advisor?

Answer 1

To minimize the risk that your clients will lose money

Question 2

Wealth management begins with

Answer 2

risk management

Question 3

Defined as the sum total of a worker’s knowledge, skills, and experience in terms of their economic value. In financial terms, it is considered to be the present value of the money a person will earn in the future.

Answer 3

Human Capital

“Human capital” can be defined as the present value of future earnings net of taxes and other deductions.

For example, if one were expected to earn $50,000 after taxes every year for the next 20 years, the present value of that income stream would be approximately $679,516 (assuming a 4% return).

In other words, $679,516 would be required today in order to generate that income stream for 20 years.

Pension Plans
Pension plans result from human capital because they are simply deferred wages.

Protecting human capital includes protecting the growing entitlement to a pension.
Clearly, a wage-earner’s future pension is part of his or her ability to earn an income.

Question 4

In creating a personal risk management plan for clients and their families, you should consider five major concepts:

Answer 4

1. How should we think about risk in the context of strategic wealth management? (How your clients view risk, and how it differs from your view as a professional)
2. How do we measure risk?
3. What is at risk within the client’s net worth?
4. How does the family life cycle affect risk management and wealth management?
5. What is the process for managing risk, however it is defined?

Question 5

What does it mean to take a holistic approach to risk and wealth management?

Answer 5

It means managing risks and wealth as a whole.

Question 6

Integrated wealth management requires that you

Answer 6

consider all of the client’s assets and liabilities and create an integrated plan to mitigate risk.

Question 7

What 2 attributes must goals have?

Answer 7

A set monetary amount

A specific time frame

Question 8

Describe pure vs. speculative risk

Answer 8

pure risk is one in which there is a possibility of either loss or no loss. For example, premature death and a house fire are both pure risks.

Speculative risk has the possibility of either a loss or a gain. For example, equity investments carries speculative risk

Question 9

Describe Objective versus subjective risk

Answer 9

An objective risk is one that most people (especially experts) agree is a risk.

A subjective risk may be perceived as a risk by one person (especially a non-expert) but not by another.

Question 10

This statistical measure of risk is standard deviation and was pioneered by who?

Answer 10

Harry Markowitz

Question 11

Measures the fluctuation around a central tendency; the greater the fluctuation, the riskier the asset.

Answer 11

Standard Deviation

Question 12

What is the fundamental weakness of standard deviation as a risk measure?

Answer 12

It assigns equal importance to the probability that a result will be higher than the mean and the probability that a result will be lower than the mean. However, the chance of getting a better result than expected is not considered a risk; only the downside is a concern.

Question 13

In many processes, random variation adheres to a certain probability distribution known as normal distribution.
This distribution is commonly referred to as the….

Answer 13

bell curve

Question 14

In a lognormal distribution, one cannot lose more than _____%

In a normal distribution, one can lose….

Answer 14

100%

an infinite amount in both directions

Question 15

This type of risk can be diversified away

Answer 15

unsystematic risk also know as non-market risk or business risk

Question 16

This type of risk cannot be diversified away

Answer 16

Systematic risk (Market risk), (undiversifiable risk)

Question 17

This risk of not meeting a specified target is called…
That target could be a rate of return, a lump sum by retirement date, or a periodic payment such as monthly retirement income.

Answer 17

Shortfall risk

Question 18

This concept of risk is used by insurers

Answer 18

Pure Risk

Question 19

This risk of loss with no upside possibility, such as a housefire

Answer 19

Pure Risk

Question 20

What are examples of objective risks?
(4 primary objective measures of risk)

Answer 20

Standard deviation
Shortfall risk
Pure risk
Time diversification

Question 21

Derives from human capital in the form of deferred wages

Answer 21

Pension Plans

Question 22

The main risk underlying a family home is the…

For that reason, advisors recommend that homeowners obtain life insurance at least matching the amount of the

Answer 22

Amount of debt outstanding against it

Mortgage

Question 23

________ risks can be statistically measured

Answer 23

Objective risk

Question 24

This refers to something that could be perceived as a risk by one person but not another person.

Answer 24

Subjective

Question 25

The life cycle could be said to have five approximate stages:

Answer 25

• Early earning years
• Family commitment years
• Mature earning years
• Nearing retirement
• Retirement

Question 26

The 5 steps of the personal risk management process:

Answer 26

1. Identify risk.
2. Evaluate risk.
3. Control risk.
4. Cover and insure risk.
5. Monitor and revise the risk management plan.

Question 27

This is another term for unsystematic risk

Answer 27

Non-market risk, specific risk, business risk, diversifiable risk

Question 28

Concept pioneered by Harry Markowitz where he used the properties of means and standard deviations of investments that are positively, but not perfectly, correlated to derive an optimal set of portfolios.

Answer 28

efficient frontier

Question 29

This is a type of risk in which there is a possibility of either a loss or a gain.

Answer 29

Speculative Risk

Question 30

It is a tool used to estimate failure probabilities of investments. It randomly generates values for uncertain variables repeatedly to mimic a model.

Answer 30

Monte Carlo simulation

Question 31

The global economy contains an irreducible amount of risk. No amount of diversification can reduce the risk in an investment portfolio below this level.

Answer 31

Systematic Risk

Question 32

These returns move in patterns over time. For example, bond returns have a predictable pattern largely related to inflation, which changes more slowly and less erratically over time than equity returns.

Answer 32

Serially correlated returns

Question 33

Financial goals must have two attributes:

Answer 33

A monetary amount and a date

Question 34

What is the first issue advisors should identify in the first step of the risk management process?

Answer 34

Risks associated with the client’s assets