Level III, 2006, morning session, question 1

2 quick things: 1. Annual after-tax interest income on his cash savings = 100k eur at the end of the year. Why are not included in next year inflows? 2. Willing to take risk: a. Effect of snake-bite effect (he avoids tech equities because of past losses) indicates less willing to take risk b. Effect of house-money effect (invested entire signing bonus in an aggressive start-up) indicates more willing to take risk c. Breakeven effect (repeated purchases of a stock as it declines) indicates more willing to take risk I don´t see why, if a indicates less willing, b can indicate more willing. I mean: he had a bad experience with tech, now he avoids tech, that is less willing to take risk, ok. But using the same argument, he invested his first bonus in a start-up which went bankrupt: + shouldn´t this decrease his willing to take risk, as with the tech stocks? + or is this “ex ante”, and means that if he had the “cojones” to do it, that means he was willing to take risk? thx a lot

  1. They are included when calculating the return from investable assets. They are blacked out in the first table as the intention of that column is to calculate the outflows starting year1. 2. If you are referring to part B - here they are looking for ability to take risk and not willingness to take risk. The over all risk taking capability is based on other factors than just the snake-bit effect. Not sure I understood you well enough.
  1. understood 1. That is what i don´t see: you get 100k this year… but also next year (and so on). Why is not included again? thx
  1. He retires in a year from now. So, they are taking the cash flow for the first year (before retirement) and matching it against the outflow. From the next year (after retirement) onwards he has a portfolio that needs to meet his needs. So, they just use the expected return of this portfolio (including the cash) and his outflow to determine his return objective.

I think now I understand: 8.73% is what he must get… on his total portfolio (that includes both his equity portfolio and the cash savings), right? This is why you don´t take into account expected positive inflows from cash (or equities), right? If this is correct, does it mean that we must never include expected interest payments or “returns from cash” when determining annual inflows, in order to calculate required return on asset base? thx again

yeah…that sounds right as per the CFAI Answer provided.