CFA mock is saying that if expected inflation is increased, risk tolerance is also increased.
I cannot get my mind around this.
Here is the CFA rationale:
If inflation is expected to increase, then institutional investor would require a higher return objective and therefore a higher risk tolerance.
Doesn’t risk tolerance constrain/drive return requirements?
isn’t this the Institutional Investor question from 2011 actual exam? [Not the mock as you have stated).
Foundation / Endowment - would have a higher return requirement - given that the Spending * Inflation * Mgmt fees - 1 (all individual components with 1 added) = return requirement.
Given the almost infinite time horizon - a higher return requirement - would in general increase the risk tolerance for the institutional investor (Foundation / Endowment as the case might be).
gotta have a higher risk tolerance if you want to meet spending requirements that are increasing due to increased inflation
CP: yes you are right. it is actually the 2011 actual exam.
Thank you and mcap11 for clearing this up for me.
I still think this is bullshit. Constraints should drive return requirement, not the other way around. Heavy inflation eats into your real value more, you don’t simply take on excess risk to combat it, thats just stupid, but hey, whatever the CFA says.
For an endowment , the risk tolerance is or should be completely driven by the dependency of the institution supported by the endowment . So if the institution depends on the endowment funding for alomst all its cash flow needs , the tolerance should be low .
The return requirement is as you said the compound sum of return , mgt fees and inflation.
However the CFAI text does say in the Time Horizon part of foundations that
“All else equal, investors often assume that a longer time horizon implies a greater ability to bear risk because a longer horizon affords them more time to recoup losses.”
(Institute 423) Institute, CFA. Level III 2012 Volume 2 Behavioral Finance, Individual Investors, and Institutional Investors, 5th Edition. Pearson Learning Solutions. . The meaning is that if they’re going to spend down the grant to zero and then shut down , it wouldn’t matter if they suffer volatility in the asset base. But if their goal is to stick round for quite a few years they have to be conservative and cannot afford to take as much risk. Its all very confusing to my formula cramming brain. However with increasing inflation I suppose the riskiness has to increase to get enough after inflation returns . Still confused about that also
Individual has willingness and ability to take risk but generally i dont think an institution has such willingness too
So if liqudity needs or return requirement raise up, an individual may not have a higher torlerance as she may not will to take that, but an institution, lets say endowment or foundation, should follow its return to raise it risk torlerance corrspondingly.
This is so frustrating… I just can’t agree with this.
So lets say we are in Zimbabwe just before 80% annual hyperfinflation… do we then set our return target to 80% plus fund costs and the spending rate and just hope we have something left when it’s all over? I get you have to protect the principal, but CONSTRAINTS should drive the return requirement! Besides, if inflation is a threat you could arguably shift to some asset allocation tilted more toward certain types of non-discretionary equities and storable commodities to hedge the inflation, and still not alter your overall risk.
What is the email address to ask these assclowns questions about their answers, and how long does it normally take for them to reply?
you will find wanda lauzierre answering your question in about 48 or so hours.
Thanks again, as always CPK.
If there is 80% inflation , you would not invest in fixed rate bonds .
You’ll become toast in no time.
You would invest in risky stocks that ride on inflation boom such as real estate or stocks engaged in export-import business that can pass on costs .
Your conservative muni or utility just wouldn’t give you the return to match the liability . Risk on applies to all investments I think , and foundation / endowments should have less problems with that , given their long time horizons
I agree you would not invest in fixed rate bonds. Or, you would go to short term cash where yields have to be repriced constantly, and i think we can all agree that short term cash has less risk than stocks. This is a bogus question, you can argue the CFAI’s side until the sun comes up and I’m not going to agree. In the absence of more information I call BS on this question.