Vol. 6 LM1 Portfolio Planning Flashcards
Types of risk objectives
A Japanese institutional investor has a portfolio valued at ¥10 billion. The investor expresses her first risk objective as a desire not to lose more than ¥1 billion in the coming 12-month period. She specifies a second risk objective of achieving returns within 4% of the return to the TOPIX stock market index, which is her benchmark. Based on this information, address the following:
A. Characterize the first risk objective as absolute or relative.
B. Give an example of how the risk objective could be restated in a practical manner.
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A. This is an absolute risk objective.
B. This risk objective could be restated in a practical manner by specifying that the 12-month 95% value at risk of the portfolio must be no more than ¥1 billion.
The case of Henri Gascon: risk tolerance
Henri Gascon is an energy trader who works for a major French oil company based in Paris. He is 30 years old and married with one son, aged 5. Gascon has decided that it is time to review his financial situation and consults a financial adviser, who notes the following aspects of Gascon’s situation:
* Gascon’s annual salary of €250,000 is more than sufficient to cover the
family’s outgoings.
* Gascon owns his apartment outright and has €1,000,000 of savings.
* Gascon perceives that his job is reasonably secure.
* Gascon has a good knowledge of financial matters and is confident
that equity markets will deliver positive returns over the long term.
* In the risk tolerance questionnaire, Gascon strongly disagrees with the
statements that “making money in stocks and bonds is based on luck”
and “in terms of investing, safety is more important than returns.”
* Gascon expects that most of his savings will be used to fund his retire-
ment, which he hopes to start at age 50
Based only on the information given, which of the following statements is
most accurate?
A. Gascon has a low ability to take risk but a high willingness to take risk.
B. Gascon has a high ability to take risk but a low willingness to take risk.
C. Gascon has a high ability to take risk and a high willingness to take
risk.
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C is correct. Gascon has a high income relative to outgoings, a high level of assets, a secure job, and a time horizon of 20 years. This information suggests a high ability to take risk. At the same time, Gascon is knowledgeable and confident about financial markets and responds to the questionnaire with answers that suggest risk tolerance. This result suggests he also has a high willingness to take risk.
Marie Gascon is so pleased with the services provided by her financial
adviser that she suggests to her brother Jacques that he should also consult the adviser. Jacques thinks it is a good idea. Jacques, a self-employed computer consultant also based in Paris, is 40 years old and divorced with four children, aged between 12 and 16. The financial adviser notes the following aspects of Jacques’ situation:
* Jacques’ consultancy earnings average €40,000 per annum but are
quite volatile.
* Jacques is required to pay €10,000 per year to his ex-wife and children.
* Jacques has a mortgage on his apartment of €100,000 and €10,000 of
savings.
* Jacques has a good knowledge of financial matters and expects that
equity markets will deliver very high returns over the long term.
* In the risk tolerance questionnaire, Jacques strongly disagrees with
the statements “I am more comfortable putting my money in a bank
account than in the stock market” and “When I think of the word ‘risk’,
the term ‘loss’ comes to mind immediately.”
* Jacques expects that most of his savings will be required to support his
children at university.
Based only on the information given, which statement is correct?
A. Jacques has a low ability to take risk but a high willingness to take risk.
B. Jacques has a high ability to take risk but a low willingness to take risk.
C. Jacques has a high ability to take risk and a high willingness to take
risk.
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A is correct. Jacques does not have a particularly high income, his income is unstable, and he has reasonably high outgoings for his mortgage and maintenance payments. His investment time horizon is approximately two to six years given the ages of his children and his desire to support them at university. This finely balanced financial situation and short time horizon suggests a low ability to take risk. In contrast, his expectations for financial market returns and risk tolerance questionnaire answers suggest a high willingness to take risk. The financial adviser may wish to explain to Jacques how finely balanced his financial situation is and suggest that, despite his desire to take more risk, a relatively cautious portfolio might be the most appropriate approach to take.
responsibilities if
a client has unrealistic return expectations
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the manager or adviser will need to counsel her about what is achievable in the current market environment and within the client’s tolerance for risk
The Case of Marie Gascon: Return Objectives
Having assessed her risk tolerance, Marie Gascon now begins to discuss her retirement income needs with the financial adviser. She wishes to retire at age 50, which is 20 years from now. Her salary meets current and expected future expenditure requirements, but she does not expect to be able to make any additional pension contributions to her fund. Gascon sets aside €100,000 of her savings as an emergency fund to be held in cash. The remaining €900,000 is invested for her retirement.
Gascon estimates that a before-tax amount of €2,000,000 in today’s money will be sufficient to fund her retirement income needs. The financial adviser expects inflation to average 2% per year over the next 20 years. Pension fund contributions and pension fund returns in France are exempt from tax, but pension fund distributions are taxable upon retirement.
Which of the following is closest to the amount of money Gascon will have to accumulate in nominal terms by her retirement date to meet her retirement income objective (i.e., expressed in money of the day in 20 years)?
A. €900,000
B. €2,000,000
C. €3,000,000
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C is correct. At 2% annual inflation, €2,000,000 in today’s money equates
to €2,971,895 in 20 years measured in money of the day [€2,000,000×(1+2%)20]
Having assessed her risk tolerance, Marie Gascon now begins to discuss her retirement income needs with the financial adviser. She wishes to retire at age 50, which is 20 years from now. Her salary meets current and expected future expenditure requirements, but she does not expect to be able to make any additional pension contributions to her fund. Gascon sets aside €100,000 of her savings as an emergency fund to be held in cash. The remaining €900,000 is invested for her retirement.
Gascon estimates that a before-tax amount of €2,000,000 in today’s money will be sufficient to fund her retirement income needs. The financial adviser expects inflation to average 2% per year over the next 20 years. Pension fund contributions and pension fund returns in France are exempt from tax, but pension fund distributions are taxable upon retirement.
Which of the following is closest to the annual rate of return that Gascon
must earn on her pension portfolio to meet her retirement income objec-
tive?
A. 2.0%
B. 6.2%
C. 8.1%
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B is correct. €900,000 growing at 6.2% per year for 20 years will accumulate to €2,997,318, which is just above the required amount. (The solution of 6.2% comes from €2,997,318/€900,000 = (1 + X)20, where X is the required rate of return.)
liquidity requirements
IPS
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The IPS should state what the likely requirements are to withdraw funds from the portfolio
* Examples for an individual investor would be outlays for covering healthcare payments or tuition fees.
* For institutions, it could be spending rules and requirements for endowment funds, the existence of claims coming due in the case of property and casualty insurance, or benefit payments for pension funds and life insurance companies.
how should managers allocate part of the portfolio to cover the liquidity requirements of clients
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This part of the portfolio will be invested in assets that are liquid—that is, easily converted to cash—and have low risk when the liquidity need is actually present (e.g., a bond maturing at the time when private education expenses will be incurred), so that their value is known with reasonable certainty.
What is the time horizon of a 55-year old pension plan investor hoping to retire at age 65
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10 years
These types of investment may be unsuitable for an investor with a short time horizon
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because the investor may not have enough time to recover from investment losses
investment time horizon
Frank Johnson is investing for retirement and has a 20-year horizon. He has an average risk tolerance. Which investment is likely to be the least suitable for a major allocation in Johnson’s portfolio?
A. Listed equities
B. Private equity
C. US Treasury bills
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C is correct.
With a 20-year horizon and average risk tolerance, Johnson can accept the additional risk of listed equities and private equity compared with US Treasury bills.
investment time horizon
Al Smith has to pay a large tax bill in six months and wants to invest the
money in the meantime. Which investment is likely to be the least suitable for a major allocation in Smith’s portfolio?
A. Listed equities
B. Private equity
C. US Treasury bills
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B is correct. Private equity is risky, has no public market, and is the least
liquid among the assets mentioned.
Describe
self-investment limits
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Pension funds also often face restrictions on the percentage of assets that can be invested in securities issued by the plan sponsor
