I continue to screw up Risk Tolerance in Case questions and I come to the AF for guidance. This is troublesome to me because this is guaranteed to be tested and I have not figured out a methodical process to go through these and nail them. Any insight on how to attack these would be appreciated. Below are excerpts from a question in the Schweser Q Bank (Q#92902) Barb Analee has a portfolio of $3 million. She retired at age 50 (entrepreneur). She has spending requirements of $110,000 + inflation of 3%. Total Return objective is 6.67%: (110,000/3,000,000) 3.67% + 3% inflation. What is Risk Tolerance? Schweser says Average Risk Willingenss: Above Average (I agree) Risk Ability: Average (I disagree) Here is what gets me. I say Above Average. To me it seems risk ability is driven by 1. Time Horizon 2. Size of portfolio relative to spending needs. Seems to me barb has a long time horizon and low spending needs (3% of portfolio). Also, in the life cycle reading it states that Wealthy individuals should be in aggressive portfolios at all times. Explanation from Schweser: Their tolerance for risk is Average. Their liquidity needs are high because of their living expenses and other needs yet they have a large portfolio so overall their risk tolerance is average. Since they are in theri retirement years, they will need a greater % of dividend and interest income to be generated from their portfolio. This is balance by their long time horizon which could exceed 20 years. Any insight on this case and methods of approaching Risk Tolerance for Private Wealth Clients would be appreciated!
leonmail Wrote: ------------------------------------------------------- > I continue to screw up Risk Tolerance in Case > questions and I come to the AF for guidance. This > is troublesome to me because this is guaranteed to > be tested and I have not figured out a methodical > process to go through these and nail them. Any > insight on how to attack these would be > appreciated. > > Below are excerpts from a question in the Schweser > Q Bank (Q#92902) > > Barb Analee has a portfolio of $3 million. She > retired at age 50 (entrepreneur). She has > spending requirements of $110,000 + inflation of > 3%. > > Total Return objective is 6.67%: > (110,000/3,000,000) 3.67% + 3% inflation. > > What is Risk Tolerance? Schweser says Average > Risk Willingenss: Above Average (I agree) > Risk Ability: Average (I disagree) Here is what > gets me. I say Above Average. > > To me it seems risk ability is driven by 1. Time > Horizon 2. Size of portfolio relative to spending > needs. Seems to me barb has a long time horizon > and low spending needs (3% of portfolio). Also, > in the life cycle reading it states that Wealthy > individuals should be in aggressive portfolios at > all times. > > Explanation from Schweser: Their tolerance for > risk is Average. Their liquidity needs are high > because of their living expenses and other needs > yet they have a large portfolio so overall their > risk tolerance is average. Since they are in > theri retirement years, they will need a greater % > of dividend and interest income to be generated > from their portfolio. This is balance by their > long time horizon which could exceed 20 years. > > Any insight on this case and methods of > approaching Risk Tolerance for Private Wealth > Clients would be appreciated! From time horizon and portfolio size perspective, yes, it indicates above average ability. However, he has significant spending requirement b/c he’s retired, he doesn’t not have a stable income to satisfy this spending need. Thus spending would depend on income generated by the portfolio. Such high dependence on his investment reduces his ability to take risk. Therefore, ability to take risk is only average.
I have a quesiton: What kind of spending needs could be called as “low spending needs”? There is any threshold?
i bet if the client in this example was still working and everything else was the same the answer would be “above average risk ability”. but, 110k/year needs to be pulled out of the portfolio so you cant lock it all up in high risk/reward nonliquid securities…
I think 6.67% is a low risk return. I think what weighs in on this situation is … if he takes too much risk and fails, that may affect his life style ( as he doesn’t work and he is not super rich) thats why average ability to take rosk. “potential affect on life style, excluding frivolous desires” affects ability to take risk.
I wish there was a rule of thumb to address this question. At this point it’s just a very subjective judgement call.
maratikus: Welcome to Level 3. Subjectivity all over the morning session exam. Cheers 
Ok I guess I have a follow up question. In the Life Cycle reading there is an overview of different Wealth Classess (Wealthy, HNW, Prosperous, Normal People) and the best asset allocation policy for each Wealth Class based on stage of life. It notes that “Wealthy” should be allocated in Aggresive portfolios at ALL life stages because they have a high amount of discretionary wealth. It notes “High Net Worth” should be allocated as follows: Young Stage: (Balanced) Middle Age: Aggressive Old: (Balanced or Aggresive) So in the above situation, somebody with a 3 million portfolio would be considered wealthy or high net worth? Doesn’t the life cycle have an effect on Risk Tolerance? Aren’t these two subject connected?
Do you think that if this is put in an essay question that we will still get marks for posting the wrong answer but providing a good explanation as to how we came up to that conclusion? Thanks!
leonmail: My 2 cents … Ability to take risk depends on … 1. Stage of life (retired / working), 2. Size of protfolio 3. Time horizon (remember some one can retire at 40 and some one at 60 , so time horizon and stage of life are different) 4. Ability to meet ones primary objectives (not alter current life style / scale down unless chosen by the investor) 5. Magnitude of the required return from the portfolio to meet primary objectives and the volatility it creates for the portfolio 6. Flexibility in pursuing additional options (not stated in the case). The decsion is fairly easy if all indicators point to one end or the other. When we have some variables on one and some on the other, then it becomes challenging. Wealth is supposed to trump all other variables. But if an investor aged 50 has 30M portfolio and has 5M living expenses/year and plans to leave a bequest of 30M, his ability to take risk is prob not above average but average. So we have to evaluate all first 5 options for above average or average ability and include the 6th option to determine average or below average ability. Hope i am on the right track … ** The above analysis is my thinking lound and no way a comprehensive analysis / breakdown***
May be i should make the below change to the above list … 1. Stage of life (retired / working) to be changed to … Percentage of day to day life dependent on portfolio return … 100% for retirees … below avg ability ot take risk (from this variable)… If retiree has pension to meet 80% of his expenses , then avg ability to take risk. ** I am just clarifying my thinking by posting**