it sounds like you are over thinking MissCleo the question is more simple than you think. All they want to know is that you know B&H outperforms CPPI in high volatility markets. Normally when people hear flat and high volatility markets they go for CM but the trick is that the client`s tolerance is over average so we eliminate CM.
I am going with BH.However i think this question went into grey areas.
If market is flat but oscillating, CM is the better choice. But since there is the possibility that at that moment, risk tolerance is at zero, it is not appropriate. CM is a contrarian strategy that assumes risk at all times. So we’re left with choosing the least bad of BH and CPPI given the F&O market environment. CPPI is terrible in F&O because it always takes the wrong bets at the wrong times, being a momentum strategy. B&H will have bought less stocks when the market goes up than CPPI and will lose less on the mean reversion.
I do agree that this is probably one of the most confusing topics in the curriculum
Generally an aggressive investor say a spontaneous investor has emotional biases like overconfidence,self attribution bias etc and they are hard to modify…so you have to “adapt” to their biases.
Hope it helps.
You are mixing questions here
I dont think so.If a spontaneous investor asks you to use BM (indirectly) instead of CM in flat and oscillating market.You have to adapt to his emotional biases.
It’s actually the same q but you are mxing subquestions here, but yes you’d have to “adapt” in that case. However, the CFA doesn’t do spillover from one question to the next so the CM vs. B&H would be an independent issue.
Lets say client invested $60 in stocks and $40 in cash (his floor) and was following a B&H strategy. Now market has gone down and his stock value is $0. This is the reason why his risk exposure and tolerance both are zero with the portfolio value equal to floor. Let’s say we now need to devise the best strategy for him. If the client has zero risk tolerance and has an intention to maintain his floor, this can be better achieved in a do nothing approach or B&H. However if the client is still more concerned with a higher return by taking some risk then CM would be the best strategy given it’s a flat and oscillating market. Under CM we now have to touch his cash and convert some of it to stocks means his floor value will no more be $40.
Found this in a previous thread - this makes intuitive sense to me.
Buy and Hold : If an investor’s equity position increases from 60% to 70%, the weight will remain unchanged at 70% (which is riskier). Good for someone who whose risk tolerance increases at the same rate as their wealth.
Constant Mix: If an investors equity allocation increases from 60% to 70%, constant mix will rebalance back to 60% (reducing risk back to normal levels). This is good for someone whose relative risk aversion remains constant, IE the proportions in the portfolio should remain constant.
CPPI: If the equity portion increases from 60% to 70%, the CPPI strategy (depending on the designated proportions) will put even more into equities (trend following) so that the ultimate ending allocation is 70+% (risk is now much higher than before). This is good for someone whose risk tolerance will increase faster than the positive change in their wealth (proportion greater than 1:1).
From the CFA texts:
_ B&H from CFAi _
_ The implication of using this strategy is that the investor’s risk tolerance is positively related to wealth and stock market returns. Risk tolerance is zero if the value of stocks declines to zero. _
(Institute 93)
Institute, CFA. Level III 2013 Volume 6 Portfolio: Execution, Evaluation and Attribution, and Global Investment Performance Standards. John Wiley & Sons P&T, 6/18/2012. .
CPPI
CPPI is consistent with a higher tolerance for risk than a buy-and-hold strategy (when the cushion is positive), because the investor is holding a larger multiple of the cushion in stocks. Whereas a buy-and-hold strategy is do-nothing, CPPI is dynamic, requiring a manager to sell shares as stock values decline and buy shares as stock val- ues rise
(Institute 94)
Institute, CFA. Level III 2013 Volume 6 Portfolio: Execution, Evaluation and Attribution, and Global Investment Performance Standards. John Wiley & Sons P&T, 6/18/2012. .
Constant mix
_ A constant-mix strategy is consistent with a risk tolerance that varies proportion- ately with wealth.18 An investor with such risk tolerance desires to hold stocks at all levels of wealth. _
(Institute 93)
Institute, CFA. Level III 2013 Volume 6 Portfolio: Execution, Evaluation and Attribution, and Global Investment Performance Standards. John Wiley & Sons P&T, 6/18/2012. .
One could make the argument that in a flat and oscillating market (and the investor is actually risk seeking with above average risk tolerance), they could also choose CM since the investor is comfortable with holding stock at all levels of wealth.
So, in theory, the risk tolerance of an individual always invested in equities (w/ no floor value) is greater than an individual who uses the B&H strategy since he/she always has some of his/her wealth in the riskless asset
Just a thought - I really have no clue.
Can we please stop saying flat and oscillating markets?
Thank you.
Why? That’s what the q said…
I know, and I find it superfluous, oscillation commonly implies stagnant and volatilite markets, not trends.
Using one or the other would automatically favour CM strategy.
Thats how I saw/see it as well. Key was the over average risk tolerance in an upwards trending market. And there B&H>CM.
The question specifically stated the market wasn’t upwardly trending but flat and oscillating.
Isn’t this post and the other one with 4 points getting too specific in discussing exam questions. Just a caution!
Right. I thought the problem has two parts:
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Flat and oscillating = CM + B&H outperform CPPI
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General risk appetite increases with the level of wealth, plus the desire to have a constant amount in cash —> B&H achieves this better than CM.
I think generally speaking, in a hypothetical situation where a client has a high/above average risk tolerance, exhibits emotional biases and is investing in a market that is volatile and/or oscillating, you would use CM
In the CFAI curriculum, they teach you that you should typically adapt to individuals with high RW and low SLR that again, exhibiit emotional biases. In order to adapt, you increase the corridor widths of the optimal asset allocation in the IPS (arbitarily 10-15% in the curriculum) which, to me, implies that rebalancing occurs but far less frequently given the emotional biases that you are adapting to (b/c you let the individual stray away from an optimum allocation which is better than having no asset allocation whatsoever). All this suggest that types of CM would be used over B&H since CM is basicaly a rebalancing strategy.
Just my two cents