Investable asset base vs spending needs and risk tolerance ability

CFA Level III
#1

How do you all decide to distinguish between a low ability to tolerate risk and a high ability to tolerate risk when comparing the investable asset base vs annual spending needs?

For example, is a 5% required real return considered a low or high ability to tolerate risk? Or is it the actual size of the investable assets that matters?

For example:

a) $5 million in investable assets vs $250,000 in annual spending would be a 5% required real return

b) $500,000 investable assets vs $25,000 in annual spending would also be a 5% required real return

Would a) be high ability and b) be low ability purely based on size of investable assets? Or would they both be high ability to tolerate? Or both be low ability to tolerate?

This is knitpicky but I’m having some trouble deciding this, and it doesn’t seem quite so obvious with most of the examples I’m doing unless I’m losing my mind.

#2

Dude, I’m wondering the exact same thing. In the 2007 exam, the real pretax need is 205k with a base of 4M = 5.13%, guideline answer says base is significant relative to need, supporting above-average ability.

Then, in the 2009 exam, real pretax need is 56,250 with a base of 1M = 5.63%. Guideline answer says base is small relative to spending levels, indicating below-average ability.

Kind of annoying - it’s not even that one is above/below average and the other is average. Clearly not a huge difference in base to need ratio, but cfai says opposite ends of the spectrum. Not awesome.

if anyone has any ideas about this, please do chime in.

ps - you’re studying for level 3. High probability you’re losing your mind regardless…as am I

#3

Ability to take risk depends on a couple of different factors, the most important which I believe are: (1) size of portfolio, (2) liquidity needs, and (3) time horizon. Also note if the client is “flexible” in any way… can he/she alter lifestyle or spending needs, or perhaps return to work again if needed? Don’t just look at the calculated return objective by itself.

That said, I think 5% is the magic number. If your client’s portfolio needs to earn a real, after-tax return that is LESS THAN 5%, then I’d say he/she has an “ABOVE AVERAGE” ability to take risk.

#4

Hey tozzert, I’m not looking at the return as a means to determine ability. Just pointing out that cfai is quite inconsistent when it comes to evaluating one of the important factors used to gauge ability. One case says base is small relative to need, in another they say significant. Meanwhile, the relative sizes of one to the other are very similar in both cases.

#5

KOT- I hear what you’re saying. I, too, have asked myself the same question when analyzing ability to take risk (apart from willingness to take risk). As I said before, you have to look at all the different factors – but less than 5% real a/t return seems to coincide with the correct answer being “above average” ability to take risk. Take that with a grain of salt…

#6

Exactly. Is their magical line 5.5%?

its not so clear as with a 2% return vs a 12% return.

Are they implying their may be some ability to reduce some expenses/spend less lavishly if you’re dropping 205k per year?

I might be spending too much time thinking about this. I’m going to call 5.5% as the tipping point and move on, 2 weeks left. Yuck.

#7

Looking at prior morning exams, there are potential questions such as “give 3 reasons why the investor has a low or high ability to tolerate risk”.

Yes, ultimately the ability to take on risk is dependent on multiple factors. Though when you actually have to explain the individual factors and their effect in isolation then this becomes a problem.