There is a statement that Constant Mix is appropriate for an investor whose risk tolerance varies proportionately with wealth.
This confuses me. I get that as the portfolio increases, there is a gradual larger absolute dollar amount of equity, but the proportion remains the same. How is that varying with wealth?
Plus as the portfolio value is falling because of a downtrending market, we keep buying equity…that is almost an inverse proportion to wealth.
Can somebody clear this up for me?
buying more equity is because overall wealth has decreased and we need to rebalance.
schweser states:
relative risk tolerance stays the same.
absolute risk tolerance is proportional to wealth.
I know it says that, but why?
Im specifically asking about the statement
“There is a statement that Constant Mix is appropriate for an investor whose risk tolerance varies proportionately with wealth.”
If its proportional to wealth, why do we add risk when wealth is decreasing?
Constant Mix - has no floor value that cushions the portfolio.
You have the objective of keeping a fixed proportion of Stocks in the portfolio.
So when the stocks market value drops - you buy more stocks - which means your cash is diminishing.
What I am seeing in my notes is Risk Tolerance for Constant Mix is CONSTANT.
For Buy & Hold - increases proportionately with wealth but is PASSIVE.
for CPPI - increases proportionately with Wealth - ACTIVE.
See this is my problem. I try to “understand” every thing, or make it intuitive.
I know what the text says, I know how the questions read, but I try to make sense out of it. I need to just move on and not try to figure out statements like
“ Constant Mix is appropriate for an investor whose risk tolerance varies proportionately with wealth.”
in the text… ^ is directly form the CFAI question guideline answers. And yes, relative tolerance is constant, but absolute tolerance increases with wealth (for some reason) .
Im trying to get to the bottom of the “proportional to wealth” thing, when we are adding stocks as the portfolio drops.
Can you point out where this was stated please?
Constant Mix is appropriate for an investor whose risk tolerance varies proportionately with wealth
Page 116, book 6, first sentence, last paragraph of section ii
Absolute tolerance increases with wealth because you have more wealth.
Let’s say you start with $100, $50 in cash and $50 in equity. The market rises, and you sell into a rising market and you end up with $150, $75 in cash and $75 in equity. Proportionally, your relative risk (i.e., cash vs. equity) stayed constant but you’re now committing an additional $25 of absolute risk to equities.
So I guess that begets the proportional thing in absolute terms, when you view it mathematically
If your portfolio declined from 100 , the equity portion would be what was declining so
it drops to 75
You rebalance to 37.50 cash, 37.50 equity…
So your absolute amount of equity decreased, even though you bought 12.50 in equity and “sold” 12. 50 in cash.
I was havign trouble reconciling the “buy equity” part with decreasing risk tolerence with wealth, but in absolute terms, you have 37.50 instead of 50.00 so that is a decrease…
But you also have $25 extra in cash.
If you sell into a rising market, it sounds like a decreasing risk tolerance. Buying into the falling market sound likes a rising tolerance when the market falls.
No, because you’re selling into a rising market to maining the same proportions of cash and equity (in relative terms).
But think of it this way, even with more cash you aren’t decreasing risk by adding cash as much as youre adding risk by adding securities.
In a rising market, what will an investor with “absolute” decreasing risk tolerance do? sell more, buy more, or short?