2011 Past Exam Q#5 Part C

CFA Level III Portfolio Management
#1

I cant understand the guideline answer for the below question, could someone explain please:

The question is from the 2011 exam Q5C “Finnegan Case”. It says in the case that her compensation was highly correlated with equity market return and currently she has 70% equities and 30% FI.

Based on that, give 2 reasons why her current allocation to equities should be lower?

The guideline answer is:

1- she is young and has a large amount of human capital relative to her financial capital

2- the correlation between her income and equity market is high. Thus, her overall allocation to “equity like” capital is extremely high, thus she should balance human capital risk through lowering allocation to equities in her portfolio.

Reason#2 is the answer that comes in mind when solving this question, but I cant understand reason number 1, what is the relation between having a large amount of HC with lowering equities in her portfolio?

#2

Her human capital is equity-like, and it represents a large percentage of her total worth.

Suppose that her human capital is 80% of her total worth and her financial capital is the remaining 20%. Then her allocation to equity is, essentially, 80%(100%) + 20%(70%) = 94%. That’s awfully high.

#3

Totally make sense now, well explained. Thanks!

#4

You’re quite welcome.