AO approach vs ALM approach

2011 morning session exam question 5 part B. One of the answer states that “Finnegan has below average risk tolerance while unemployed. Loss averse investors, or investors with below average risk tolerance, are better suited to an ALM approach than to an AO approach”. Is this statement correct? Why risk tolerance can be used as a guideline for which approach should be adopted? If there is no liability at all, loss averse investors are still better suited to an ALM approach?

A below average risk can use ALM because now they can guarantee their expenses will be paid. You can think of expenses as their liability. That’s why the lifetime expenditures are part of the liabilities on an economonic balance sheet.

I think the main point is you aren’t reading the passage at all and just looking at the solutions. Inside the passage is she has to make mortgage payments and therefore she would risk losing her home if she misses payments. It’s a contractual liability that she faces.

Yes, that question ask you to provide 3 reasons why the ALM should be used. “she has to make mortgage payments and therefore she would risk losing her home if she misses payments. It’s a contractual liability that she faces.” is one of the answer. You have to provide 2 more reasons. The other reason they give to you is ““Finnegan has below average risk tolerance while unemployed.” I am confused with this one.

While she is unemployed, she has no income… That means she has to increase liquidity from pulling out investments… Increase in liquidity needs means lower risk tolerance.

This is not confusing. Think that an Asset Only approach is a great one it you have a surplus over liability. Because with a surplus your risk tolerance increases manifold. Being unemployed literally means an invading portfolio. If the Time Horizon is large enough and if the situation is not expected to alter(for better) then an invading portfolio will eventually give way to probability of ruin. To avoid the same either a negative surplus could be thought of or the entire situation can be modeled by an ALM approach. This should suffice.