In 2001AM exam set, question 7 gives a scenario for Stephenson aged 55 (high risk tolerance, very low liquidity needs, high income, low expenses and long time horizon leads to above average return objective). Twenty years later, the scenario worsens in question 9 for Stephenson. He has lost significant asset value, has no income, high expenses. So, his risk tolerance is significantly lower. But the model answer says his return objectives have increased. When risk tolerance has decreased, increasing return objectives seems to lack internal consistency of the IPS. Many of the other IPS I have seen seem to let the risk tolerance drive the return objective. Comments?
Is it that his required return has increased, since he can’t immediately reduce his expenses even though his asset base has shrunk? not sure b/c I’m not looking at the ?
Yes his asset base has shrunk, income has gone to zero (retired), while expenses remain. So, possible recommendations can be a. reduce your risk tolerance, lower return expectations to avoid shrinking asset-base further, reduce expenses b. increase your income (i.e., work more) c. increase your return by increasing risk tolerance (at the risk of possibly shrinking asset base further) Out of them choice c) does not seem prudent to me. The guideline answer goes a step further to say reduce risk and increase return requirements!