PWM Allocation

V2 Reading 14, Page 424, Problem 3: Lee is a 35-year old equity trader with an average annual income of $200,000. Lee’s income exhibits a 0.90 correlation to the performance of the S&P 500. What is his optimal allocation. Solution: The optimal allocation of financial wealth becomes more weighted towards risk-free assets, than would otherwise be indi- cated based on age, as income and stock market returns become increasingly correlated. At a 0.90 correlation between Lee’s human capital and the stock market, the optimal allocation is 20% to the risk free asset and 80% to stocks. Assuming weaker correlations between his income and the S&P 500, the allocation to the risk free asset will be lower and allocation to stocks will be greater. Is this accurate? I am confused… if your paychecks are highly correlated to the stock market, wouldn’t you be investing more in the risk free asset? What the heck am I missing?

Yes, you should.

This is one of a pair of confusing (almost contradictory) questions in the curriculum.

I encourage you to focus on the general conclusion (which you already formulated) and not on the specific numbers (20%, 80%) in this particular answer.

Thanks for the confirmation! Will report the typo… definitely looked confusing, so wasn’t sure initially.

I had lots of candidates in 2013 ask me about this one and its companion: confusing is right.

Lee is relatively young ( i.e. has much bond-like human capital ) So the recommended allocation might be 100% to equities. But since his job is correlated to the stock-market , considering the joint-risk , a more prudent allocation would involve some amount of bonds ( typically 20%)

CFAI has not backed off from this answer inspite of several questions posed to them by June 2013 candidates. Use the search function.

This chapter is all about relative merits of allocations for a case , and frequently you should not look sideways at another case to determine allocation for the case you’re studying

Thanks for posting this question Aether, I was also very puzzled by the answer, and still not sure that it makes sense. The mighty CFAI never makes things easier for us!

welcome to level iii

+1 Yes, let the confusion begin. I can’t tell you how many times I yelled at my books for answers that I thought didn’t make sense. Forget what you already know, just read the material and say “Yes Mr. CFAI, you are correct”.