A Little Game Theory For Ya (kind of)

So as I’m sitting here taking Schweser 3AM (from Book 1, question 8.b.ii), I’ve come across a question that I truly don’t know the answer to - whether life insurance is more preferred for bond-like human capital or equity-like human capital (I’ll know it and remember it as soon as I grade this exam, but I’m truly stuck right now). I’ve thought about it and can argue either side equally, so this for me right now is truly a 50/50 toss up, as they’re asking it for two different investors, and the answer for one is obviously not the answer for the other. So this 50/50 situation kind of got me thinking a little bit, and how I’d treat this situation on exam day, so I thought I’d share. Since I feel like I’m doing pretty well on this test, I’ve decided to put “high” for both investors, knowing that one will be correct and one will be incorrect, and take the 50% of points as somewhat of a safety net to my (in my opinion) already fairly strong score. Now, if I was feeling like this test was crushing me and I was going to “at best” be borderline, the best move for me (in poker we’d call it a “max EV move”) would be to put different answers and go for the full 100% (and risk 0%), as the incremental benefit of me getting full credit outweighs the downside of 0% when I was struggling to pass anyway. Just figured I’d share that in case this situation arises on exam day.

I like the approach. And you knowing the names of Poker moves I can say that I’ll never want to be across the table at a poker match with you. I think CFA is a little more skilled in their test writing vs. Schweser though and not sure if we’ll see many opportunities to hedge and answer for a 50%. If I don’t know the answer I hope they do.

Yeah, come across similar decisions, and like you say, it depends on how you are doing on the exam to that point. If you are getting slaughtered, better go for it all, otherwise take the sure half. The answer, by the way, is people with bond like income should have a higher demand for life insurance. LI is a hedge for human capital. If your HC is bond like it has a higher present value than one that is equity like, because equity like HC is discounted at a higher rate. Higher PV of human capital means higher demand for life insurance as a hedge. I thought this was a very interesting way to look at it when I read the chapter so I’ve never forgotten it.

uhhh… this probably isn’t good to be asking at this point, but: What is an example of “equity like Human Capital” ? Its been a while since i’ve reviewed that stuff. :confused:

I always think of it as a sales job - for instance, a car salesman has pretty volatile earnings and it can go up/down with the economy, so that would be more equity like.

Stockbroker would have equity like human capital. Tenured professor bond-like human capital.

wait, so is that right- more bond like your human capital, more need for life insurance? i’m not being sarcastic. for a smart girl, i haven’t studied nearly enough. someone confirm and this will be locked into my memory forever.

Yep that’s right. Good explanation by Chi Paul that I won’t forget.

bannisja Wrote: ------------------------------------------------------- > wait, so is that right- more bond like your human > capital, more need for life insurance? > i’m not being sarcastic. for a smart girl, i > haven’t studied nearly enough. > someone confirm and this will be locked into my > memory forever. Confirmed, and I too will never forget this.

thank you guys/girls, especially if that shows up on test day. that is a great way to think about it chi-paul. GIPS is makin’ me crazy. 18 more q’s and i’m done with q-bank on ss18. while not an ideal study tool, it has taught me a few memorization type things and easy calcs. i’ll do the CFAI EOC’s on it next. I plan to know GIPS fairly well by dinner time. i’m really glad i took off the week before the test to give myself a fighting chance here. you folks are amazing motivators and keep me on point for 2 weeks. if i can pass, it’ll be barely, but i keep some strange hope that i can get just smart and lucky enough on test day to do this even though my effort until the last few weeks has been marginal at best.

Did anyone else find the absence of EOC questions frustrating here? It is pretty clear how this ties into the IPS stuff, but how do you think it will be tested? I’m curious to hear your thoughts. Here are mine: Topic: Human Capital: I can see a vignette and then one of those 3 point each “agree or disagree and explain” questions that asks us to integrate the life insurance decision with the asset allocation decision. We may have to identify whether the given action (diversification, life insurance, annuity) was the appropriate way to hedge the 3 risks associated with Human Capital (earnings risk, mortality risk, and longevity risk). Key phrases I highlighted in the text include “the investor’s demand for insurance decreases as she ages…the magnitude of loss of human capital at younger ages is far more important than the higher probability of death at older ages.” “bequest motive has little effect on optimal asset allocation.” “optimal insurance demand increases with risk aversion.” and as stated above, “an investor whose human capital is less risky than the stock market…(has) smaller life insurance demands.” Topic: Asset Allocation and Insurance I have a feeling that the 3 Risk factors in retirement (Financial Market Risk, Longevity Risk, and Spending Uncertainty) will be tested. When the text states “Investors often ignore market risk by assuming a constant rate of return from their portfolio, and as a result make inappropriate asset allocations,” it seems to me we will be tested on it. A year after we witnessed financial Armageddon, I expect I will be asked to state that “it is unrealistic for the investor to make decisions based purely on average return. Doing so underestimates the risk and investors are generally risk averse by nature.” This is a rich topic as the reading on Longevity Risk and hedging it with various type of annuities was another point where the CFAI text gets it right (instead of just asking us to restate an invalidated academic theory that is not practical because the standard state requirements are always violated in the real world). I think we will have to know that “Because Mean-Variance optimization (referred to elsewhere in the CFAI text as the “gold standard”) addresses only the risk & return trade-offs…rational investors will want to hedge away the financial aspect of Longevity Risk because there is no potential financial reward for this type of risk exposure.” Apologies for the lengthy post but I was reviewing notes and trying to guess how/what would be tested.