Pretty basic question that I’m not too happy about cause I’m not getting it…
Welsh believes Finnegan should reduce her allocation to Equities at this time.
One of the answers is:
Because Finnegan is YOUNG, and has high HC compared to financial capital Finnegan should have a lower allocation to equity
I thought if you’re young and have High HC, we should be taking more risk and have a higher allocation to Equity.
Why is this an exam answer?
Don’t have the details
Principle is that “young” means tons of HC hence you should invest FC in Equity UNLESS your salary is pretty much correlated with stock
market therefore in order to diversify risk you should invest in Risk free assets.
Hope it helps,
Your explanation is how I see it. But in the answer as a reason to why Finnegan should reduce equity allocation is beacause:
Finnegan is YOUNG, and has high Financial capital.
That reason is why, I think the equity allocation should be HIGHER not lower.
Nope I recall now it’s a bloody tiny, hidden exception :
If you have HIGH FC since the beginning of the story i.e. INITIAL FINANCIAL WEALTH is pretty large then you need less risk to accumulate savings ( you are already rich!), your HC weighs less in the total wealth,
that’s why you invest resources towards risk free assets. You don’t need to undertake risk you just need to maintain in a wat your current wealth.
Subtle, filthy, bloody exception.
P.S. It’s included in the chapter "impact of initial financial wealth: “the optimal allocation to the risk-free asset increases with initial wealth…an in increase in initial financial wealth not ony increases the total wealth but also reduces the % of total wealth represented by HC…”
you missed the second bullet point which says: "The correlation between F’s income and the equity market’s performance is high. Thus, her overall allocation to “equity like” capital is extremely high"
I understand the second bullet point. But the question asks you to justify with two reasons. Being young is one of them and the one I dont understand.
And Sunseeker. I’ll take a look. But again, the solution doesn’t state what you’re saying. I do remember that as well --> What you mentioned.
There was another post discussing this: http://www.analystforum.com/forums/cfa-forums/cfa-level-iii-forum/91349969
Now that I have a clear read of it, I’m not sure I understand it either.
Word for word answer from CFAI.
- Finnegan is young and has a large amount of human capital relative to her financial capital
- The correlation between Finnegan’s income and the equity market’s performance is high. Thus, her overall allocatino to “quity like” capital is extremely high. Investors whose human capital is highly correlated with equity returns should balance human capital risk thorugh a lower allocation to equities in their investment portfolios.
I understand the second point completely but I do not understand the first point. Younger means higher equity allocation, not lower. I don’t have the questions with me right now because I’m at work but I remember that Colleen is unemployed so she definitely is not wealthy. Unless unemployed means less risk tolerance and therefore lower equity allocation.
I would say her human capital is risky as she doesn’t have a job and therefor should have a higher allocation of Fixed Income and lower equity. Remember them mentioning, a professor would have safe labor income and therefor would need to have a higher allocation to Equity.
Hei so. Do you think thats ok for the second justification? i understand the one with correlation
^ I just wished the answer key would specify that. It only says ‘Finnegan is young’. But does not say anything regarding the unemployment.
I think YOUNG shouldn’t be in there. I’ve talked to others and they thought the same.
I have issue with this as well. I think the answer is not very written and is misleading (Can’t belive this!). This answer actually bothers me a lot.
The major reason should be his salary is stock like, that’s why he should decrease his equities.
I think CFAI is trying to say because his salary is stock like AND he is YOUNG, thus his HC has a large portion in his assets, that’s why he should decrease the equities.
But I don’t agree that they should list being young seperately from his HC and as the 1st bullet point, which caused a lot confusion and contradicts with CFAI’s rule of thumb that young investors should invest more equities.