Fundamentals of Investment Theory

Question 1

Give examples of Client Objectives

Answer 1

1) Stability of Principal
2) Income
3) Growth of Income
4) Capital Appreciation
5) Asset liability matching

Question 2

Give examples of Client Circumstances

Answer 2

1) Financial Needs
2) Risk Profile (Risk Aversion / Risk Tolerance)
3) Constraints

Question 3

What should you avoid exposing a client to, regardless of time-horizon

Answer 3

Unnecessary amounts of risk

e.g. if aim is CPI+2% - no need for large equity allocation, regardless of time horizon.

Question 4

What is the formula for Risk Aversion?

Answer 4

1 / Risk Tolerance

Question 5

What is the formula for Risk Tolerance

Answer 5

1 / Risk Aversion

Question 6

What are the 4 types of annuity?

Answer 6

1) Variable
2) Deferred
3) Conventional
4) Guaranteed Annuities

Question 7

What is a variable annuity?

Answer 7

Variable value based on performance of investment.

Level of income paid in retirement is variable

Question 8

What is a deferred annuity?

Answer 8

Income commences at a a later date (will be paid at a higher amount)

Risk of dying before deferred period kicks in.

Question 9

What is a conventional annuity?

Answer 9

Secured income for life - in exchange for a lump sum.

Pays fixed sum regardless of interest rate risks

Question 10

What risk is there to the issuer of a conventional annuity?

Answer 10

Buyer may live for a long time

Question 11

What is a guaranteed annuity?

Answer 11

Guarenteed sum paid - if client dies, estate receives remainder.

Question 12

List 3 other features of annuities

Answer 12

1) Inflation Linked
2) Escalation Rate
3) Joint Annuities (e.g. 50% to spouse on death)

Question 13

6 Investor risks

not investment risks

Answer 13

1) Capital presevation in monetary terms
2) Preservation in real terms (purchasing power/inflation)
3) Avoiding undesirable outcomes
4) Possibility investment may fail
5) Liquidity risk (can’t raise cash when needed)
6) Relability of regular income stream

Question 14

What is utility?

Answer 14

A feeling of well-being

The optimal portfolio is the one proiding the highest utility

Question 15

How is utility calculated?

Answer 15

Return on Portfolio - (Variance / Risk Tolerance)

Question 16

What are the 4 age/life-cycle stages

Answer 16

1) Foundation Phase
2) Accumulation Phase
3) Maintenance Phase
4) Distribution Phase

Question 17

What is the foundation phase?

Answer 17

Starting to build an income and create wealth

High tolerance to risk (but large losses in first 3 years and put an investor off)

Question 18

What is the accumulation phase?

Answer 18

Career has been build - assets available for investment increase (accumulate funds for retirement)

risk tolerance can increase

Question 19

What is the maintenance phase?

Answer 19

Closer to retirement - focus shifts on maintaining lifestyle / financial security

Risk tolerance falls sharply

Question 20

What is the distributinon phase?

Answer 20

Accumulated wealth now available for distribution

Tax saving measures now important

Question 21

What is the purpose of a client risk questionnaire?

Answer 21

To determine a clients appetite and tolerance towards risk

Question 22

What is useful about a client risk questionnaire?

Answer 22

Quantifies an investors attitude to risk

Question 23

How many options should be given to clients on a questionnaire?

Answer 23

An even number to avoid mid-points and fence setting

Question 24

How should questionnaire choices be written

Answer 24

1) Clear
2) Unambigous
3) Concise

Question 25

3 benefits of a client risk questionnaire

Answer 25

1) Easy to calculate and explain
2) Can update to track client’s change in attitude
3) Can allocate different portfolios despite similar objectives

Question 26

2 drawbacks of a client risk questionnaire

Answer 26

1) It does not include need or capacity for risk
2) Risk aversion changes - may not be constantly accurate

Question 27

What is a certainty equivalent?

Answer 27

a guaranteed return that someone would accept now, rather than taking a chance on a higher, but uncertain, return in the future

helps an investor choose between risk free rate and an investment

Question 28

Give an example of Socioeconomic characteristics

Answer 28

Women save at a greater rate & are more risk averse than men

or

Families have a greater saving propensity than single individuals

Question 29

List 9 types of investment risk

Answer 29

1) Systematic (market) risk
2) Unsystematic Risk
3) Inflation Risk
4) Interest Rate Risk
5) Exchange Rate Risk
6) Capital Risk
7) Event Risk
8) Political Risk
9) Operational Risk

Question 30

How do you find portfolio risk given systematic and unsystematic risk

risk figures given as standard deviations

Answer 30

Square them, sum them, root them.

Question 31

What does correlation measure?

Answer 31

The direction and strength of two variables relationship

Question 32

What does covariance measure

Answer 32

non-standardized measure of the direction of a relationship

Divided by the sum of the variables standard deviations, it gives correlation (standardized)

Question 33

When does the most effective diversification occur?

Answer 33

When combining two negatively correlated assets

Question 34

What is the formula to find the standard deviation of a series of assets (given weightings and SDs)

Markowitz

Answer 34

(Weighting^2 * SD^2) + (Weighting^2 * SD^2) + (2* weight * weight)*(correlation * sd1 * sd2)

Question 35

What is mortality risk?

Answer 35

the risk that their investments are unable to support an investor for as long as they require (ie, until they die).

relating to annuities usually

Question 36

Do be considered a risk free asset, what two conditions must be met?

Answer 36

1) No Default Risk
2) No Reinvestment risk

Question 37

What asset is generally used as the risk free rate?

Answer 37

3 Month T-Bill