CPPI or Buy and Hold?

EOC question #7b has this stated in the passage:

  1. High Risk tolerance.

  2. Bull Market

  3. Dont want the market value of the portfolio to decline more than 15%.

  4. Low volatility in returns expected.

The answer is CPPI but I chose Buy and hold. With regards to comments 2 and 3, I think that could be CPPI or buy and hold. Both have a floor price and outperform in an UP market.

Risk tolerance is higher for a CPPI but it also increases in an “UP” market for a Buy and Hold.

I’m assuming it’s the fourth comment that justifies the CPPI answer. But even with that, I chose Buy and Hold. Because if volatility is low, the returns should be flat and the Buy and Hold is neutral in flat market whereas a CPPI UNDERPERFORMS badly in a flat market.

I might be off in more than one spot above with my responses but thats how I see it. Any help is much appreciated.

Ignore my comment above. One of those days. Rest of the solution was on the next page.

CPPI does poorly in high volatility environments and this is a low volatility environment.

Anyways, thanks. But good question for those who attempt it.

All 4 characteristics described above indicate CPPI as the best solution. Not only trending market.

Which is the most appropriate strategy given the investor is willing to invest a greater proportion of his wealth in risky assets as his portfolio value increases and the market will be flat but oscillating? Buy and hold or Constant mix?

B&H is better solution for investors whose risk tolerance is proportionate with wealth level.

Ambiguous, but Constant Mix will outperform B&H under the above market condition. In my opinion though, the willingness to invest a greater proportion in risky assets as wealth increases trumps the current market condition over the longer term, thus B&H may be more appropriate. I’d lean towards B&H here.

^ IMO, If the only criterion for choosing appropriate strategy would be how certain strategy perform under both market conditions, trending or non trending, then B&H would never be chosen by any investor and that’s not correct. Thus, additional criterion should be considered upon each investor’s preference and upon situation.

I think that’s what I’m saying, but maybe didn’t convey it correctly. B&H certainly wouldn’t be chosen in a non-trending market unless other factors in an individual investor’s situation held more weight than current market conditions. The curriculum really doesn’t go into the fact that markets will fluctuate between trending and non-trending over time, and if investors should consider changing their rebalancing strategy based on those conditions (maximize performance) or not (focus on risk management). I found it odd that the curriculum focused more on the return functions of the three strategies and less on risk management considerations. Of course it very well may have and I missed the forest through the trees. I’ll be back reviewing that reading relatively soon.

Agree. Me, too. There are many confusing things. I often miss crucial detail. How are you doing on constructed responses?

Thank you for your input guys. The correct answer as per the past years(2016) paper is Buy and hold.I wrote Constant mix because of the sole reason that it performs well in oscillating markets. The answer says constant mix is consistent with a constant risk tolerance it does not change with proportion of wealth. What still confuses me is the absolute level of wealth changes as portfolio value increases in constant mix doesnt this increase his willingness?

Well, I am not sure if is exact answer on your question, but it helps me to determine which model to chose regarding willingness to take risk. Recall the graphs of each model and remember that for BH is linear while for CM is concave and for CPPI is convex. Then, recall same graphs from Behavioral Finance and you may conclude that convex is linked to risk seeking investors while concave is linked to risk averse investor. Linear graph shows indifferent investor. That might be a link. I am not an expert for this area.

Ah, B&H afterall. Looks like I was on the right track with my reasoning.

To answer your question, no, a greater absolute level of wealth does not necessarily imply or generate a greater willingness to take risk. It may increase ability, but not necessarily willingness. In fact, in some cases, greater wealth can decrease an individual’s willingness to take risk. I’ve seen this in my own practice with one of my clients. As he reached a certain level of net worth, and accounting for fixed sources of income (pension and social security), he saw little reason to take much if any risk with his investment assets. His primary spending needs in retirement were easily met, and simply maintaining purchasing power and slowly utilizing principal to meet additional spending needs over time was satisfactory for him. He had the ability to take more risk, but he didn’t see value in doing so as the fear of short term market loss dominated over his ability to achieve greater long term returns.

Meh I really veered off there. The point is, constant mix maintains a constant exposure to risk, where exposure to risk in B&H increases and decreases linearly with the level of overall wealth. For exam purposes, it seems to me that this should likely be the dominant criteria when selecting a rebalancing strategy, rather than performance. We should be expected to know which strategy performs better or worse under different market conditions though.

I haven’t started past AM papers quite yet, but I’ve done all the EOC written answers. While the EOC questions are sometimes in a format similar to what I might expect to see on the actual exam, with the occasional “explain”, “justify” and “calculate” command words, I didn’t find them to be the best place to practice for the AM session. I always ended up getting way too wordy, often because of the way the question was asked. I’m hoping to get that all dialed in over April and May as I start cranking through past AM papers and hopefully get reasonably good at time management.

As you might be able to tell I can be wordy, and I know I can’t do that on the exam unless I want to fail in epic fashion.