What does everyone think about the ability of younger investors to take risk? In Life-Cycle Investing they state that Not Wealthy/Prosperous should be conservative when young; however one section (I can’t remember off the top of my head) talks about the interplay of financial and human capital and states since younger investors have lots of human capital (and human capital is bond like and they have the ability to spend less/save more) they should be able to take more risk in financial capital (also stating they may be 100% invested in stocks)? What approach should we be taking on the exam? -Thanks.
I recall these readings however I believe the reading you refer to as ‘Life-Cycle’ investing was somewhat contrarian in nature. I personally adhered to the structure of builing a personal balance sheet which incorporates financial and human capital. As you noted human capital has the characterstics of a bond and as a result the younger investors should invest fully (100%) in equity. The other reading argues that because younger investors have little financial capital to weather a financial disasters (job loss, etc.) that they should have a conservative portfolio of fixed income only. Subsequent to building up a financial base they can diversify to a greater extent into equity. However as I noted I viewed this argument as highly contrarian in nature but interesting none the less.
Thanks for the input Input, this is exactly what I am talking about and I agree with you. However, are we suppose to state the interaction between human and financial capital on the exam (young investors can take great risk) or go with the Life Cycle stance (young investors do not have the ability to take risk)? I guess what the questions is, is what the hell is CFAI looking for on this topic? -Thanks.
I think you have to address the issues with both… i.e. they are young so have the ability to take risk but they might also have significant future liabilities which might preclude them from doing so.
usually for a young investor… if the portfolio is not required to meet spending needs(salary shortfall) then above average ability to take risks… Ability to take risks mainly depend on time horizon
Zidane nailed it. What fraction of income comes from portfolio? What are near-term liquidity needs?
Unless other evidence contradicts in the question: Younger = More Risk Ability Longer Time = More Risk Ability Larger Asset Base = More Risk Ability Less Liquidity = More Risk Ability Most Expenses Covered via Income = More Risk Ability . . . What else can we add…Also remember their is Willingness and Ability…
So I think about risk profiles of the portfolio as: Portfolio risk = Minimum(Ability to Take Risk, Willingness to take Risk). Is there any time that this is not the case? (e.g. high ability, low willingness)
You can have a high ability and think that you have a low willingness BUT you were invested in Small Caps for the past 20 years and received 20% annlzd returns…Hence your willingness should be labeled as above-average. You would have to talk to your client and explain to them that historically SC’s are riskier assets than LC stocks and yada yada yada… So no your method doesn’t always work unfortunately! Thats the Joy!
Ok, how about this revision. The Min() formula still applies, *but* willingness to take risk can now be either A) Stated willingness to accept risk, or B) Revealed willingness to accept risk, based on past investment behavior. If there is an inconsistency between A and B, you then have to have a discussion with the client to reconcile the two, and either: 1) Client will decide that they were unknowingly taking on too much risk and ask you to reduce the risk of their profile, or 2) Client will decide that they can handle more risk after all, and up their perceived “willingness” Would this modified procedure cover the bases?
haha…can I have the executive summary
“We asked a question and came to conclusion that A and B leads to either 1 or 2. Which one you choose is critical for the success of a firm.”
Input Wrote: ------------------------------------------------------- > I recall these readings however I believe the > reading you refer to as ‘Life-Cycle’ investing was > somewhat contrarian in nature. I personally > adhered to the structure of builing a personal > balance sheet which incorporates financial and > human capital. As you noted human capital has the > characterstics of a bond and as a result the > younger investors should invest fully (100%) in > equity. The other reading argues that because > younger investors have little financial capital to > weather a financial disasters (job loss, etc.) > that they should have a conservative portfolio of > fixed income only. Subsequent to building up a > financial base they can diversify to a greater > extent into equity. However as I noted I viewed > this argument as highly contrarian in nature but > interesting none the less. I haven’t seen an IPS explicitly mention the use of human capital as one of the inputs to determine asset allocation. Normally, a long time-horizon implies better risk taking ability. Never seen one explicitly state human capital is high and as as result debt allocation is also high (say, x years * wage$) necessiating higher equity allocation in the financial capital.
Ability will almost dominate willingness low ability, low willingness --> low risk tolerance low ability, high willingness --> low risk tolerance high ability, high willingness --> high risk tolerance high ability, low willingness --> low risk tolerance (usually) In case of high ability, low willingness the adviser will talk to client, especially if assuming lower risk level may jepordise meeting the stated return goal. He will explain that with lower risk level goal may not be attainable, and client may be able to have high risk tolerance. If client still refuses to accept higher risk, risk objective will then needs to be revised.
I thought in cases of conflict between ability and willingnes to take risk , we have to go with the willingness to take risk .
if your ability is low and willingness is high (lets say you depend on portfolio income for living expenses), your high risk tolerance (aka willingness) becomes irrelevant (relativelly speaking), since you can’t allow to have large losses (you may not have enough money to buy food [i am exaggerating]), which are more likely to happen if higher risk is taken, so ability dominates
No, I believe that ABILITY > Willingness. If I have $1,000 and I need $10/month to meet expenses, then my ability say would be low b/c I need the $10 or else I’m on the street, but my Willingness might be all in.
I meant in the situation where you a large asset base but are not willing to take a lot of risk …
I meant in the situation where you a have large asset base but are not willing to take a lot of risk …
If the investor specifically states that I know my ability to assume risk is above average, but I prefer to have a low/avg risk portfolio then the overall risk will be avg/below average b/c of the investors preference. So yes, if you have an investor that wants a low risk portfolio than by the power vested in me he/she shall have a low risk portfolio. BUT if the investor wants a low risk but high return I will slap them silly and tell them about the risk/reward payoff game that we like to play…