Reading 10 Flashcards
Discuss how: - source of wealth - measure of wealth - stage of life affect an individual investors' risk tolerance
Source of wealth: - Active wealth: risking financial capital e.g. entrepreneur higher willingness to take risk - Passive wealth: accumulation e.g. inheritance, saving salary over time lower willingness to take risk
Measures of wealth:
- High perceived = high willingness to take risk
- Low perceived = less willingness to take risk
Stages of life:
- Younger investors (foundation) = higher ability to take risk
- Mid-career (accumulation phase) = high ability to take risk
- Retirement (maintenance and distribution = reduction in ability to take risk
General inverse relationship between age and risk tolerance
Explain the role of
- Situational profiling -
in understanding an individual’s attitude towards risk
Situational profiling = individuals into categories according to:
- stage of life, of
- economic circumstances
First step in understanding individual’s preferences
How:
- Source of wealth
- Measure of wealth
- Stage of life
Explain the influence of investor psychology on risk tolerance and investment choices
Behavioural models may assist the manager in understanding the client.
May start with a client questionnaire
Two categories
1) Higher vs lower risk tolerance
2) Decision process
Four general categories: 1) Cautious investor risk averse, feelings 2) Methodical investor risk averse, thinking 3) Individualistic investors less risk averse, thinking 4) spontaneous less risk averse, feelings
Explain benefits, for both
1) clients
2) investment advisers
of having a formal investment policy statement
1) Clients
- objectives and constraints are considered in formulating investment decisions that benefit the client
- process is dynamic; allows changes in circumstances
- long-term objectives of the investor
- subsequent managers can implement decisions congruent with the individual’s goals
2) Adviser
- can be consulted to check appropriateness of specific investment decisions
- stated review process
- indicate dispute resolutions
- identify potential problems
Explain process of creating an investment policy statement
- Determine investor’s risk and return objectives
- return objectives in line with risk tolerance discussions - Determine portfolio constraints
- Define the appropriate investment strategy, considering:
- objectives
- constraints
- market expectations - Determine proper asset allocation to meet objectives
- an SAA is sometimes included
Distinguish between required return and desired return, and explain how these affect the individual investor’s investment policy
Required return:
- required expenditures are mandatory and, along with value of investable portfolio, are used to calculate the client’s required return
Desired return:
- desired expenditures are non-primary goals e.g. vacation home, luxury holidays. Not considered when calculating total investable portfolio or required return
Explain how to set risk and return objectives for individual investor portfolios
+ve correlation with ability to take risk
- portfolio size vs. needs
- total wealth vs. needs
- time horizon
- flexibility
- willingness (although subjective)
- ve correlation with ability to take risk
- goal importance
- level of spending needs
Ability to take risks can be understood by:
- explicit statements
- situational profiling
Discuss the effects that ability and willingness to take risk have on risk tolerance
The overall risk tolerance conclusion generally goes with the lower of:
- ability
- willingness
Discrepancy between the two should be noted
Deferring to the more conservative measure is the preferred method
Discuss the major constraint categories included in an individual investor’s investment policy statement
- Time horizon
Stage = a change in circumstances significant enough to require evaluating the IPS and reallocating the portfolio e.g. retirement, major expenses such as college costs, expected inheritance
- Tax considerations
- Liquidity
Sepnding needs that will be met by the investment portfolio. Assume the client will use current income from portfolio and/or liquidate assets as necessary to meet spending needs
- Legal and regulatory factors
Typically relate to tax relief and wealth transfer
Depend on jurisdiction.
Usually require legal advice
- Unique circumstances
Prepare and justify an investment policy statement for an individual investor
- The investment policy statement is a document that is developed as the result of a client interview to determine:
1. Their risk (ability and willingness)
2. Return objectives
- Five considerations
a) time horizon
b) unique circumstances
c) taxes
d) legal and regulatory
e) liquidity constraints - Asset allocation
- determined and implemented
- monitored
- subsequently revised as needed
Determine the strategic asset allocation that is most appropriate for an individual investor’s specific investment objectives and constraints
SAA can be selected using a process of elimination Asset mixed that do not: - meet required return - exceed allowable risk - violate constraints = eliminated
Allocations with excess or insufficient cash are eliminated
If more than one acceptable SAA remains, then diversification can be considered following the generalization that an average risk investor would be allocated 60% to equity (growth) type assets and 40% to bond (fixed income) type assets.
If necessary for final selection; SAA with higher return to risk is selected
Compare Monte Carlo and traditional deterministic approaches to retirement planning and explain the advantages of a Monte Carlo approach
Deterministic = single value for economic and financial variables e.g. expected rates of return, inflation, interest rates assigned single point estimates as inputs to modelling to estimate assets available for retirement period. Generates only a single number. Investors do not have the capability of evaluating probabilities of that expected value occurring.
Monte Carlo = takes into account distributions and associated probabilities for input variables. Provides a probabilistic forecast of retirement period values. Instead of seeing one single outcome, the investor can see a range of possibilities for the future
- Probabilistic forecasts: more indication of risk/return tradeoff in investment decisions
- MC simulations explicitly show tradeoffs of short-term risks and not meeting short term goals
- MC can incorporate tax nuances
- MC can better model the complications associated with future returns by more effectively incorporating the compounding effect of reinvestment
