# Reading 14 (EOC Question 2) (HELP!)

Hi guys,

I am having trouble with question 2. Reading 14. More specifically with wu’s asset allocation.

Data:

1. Wu’s HC is equitylike.

2. Age is 35

3. Moderate risk tolerance

To start with I read in schweser that for an average investor the general rule of thumb for asset allocation is 60% equity and 40% bond. Just a thing that might come in handy. Anyway lets try and think about what proportion of his total wealth is HC. lets say a person starts working at 25 and ends at 65 (40 years of work). assuming most or all of ones wealth is HC at start of working life and it linearly converts into FC as retirement approaches. His current proportion of HC would be. (65-35)/40 = 75%.

So WU has 75% HC and 25% FC.

Now I am assuming that we are shooting for 60 equity and 40 bond which seems to be what schweser has advised is good for average investor. I am assuming average investor would have moderate risk tolerance.

So we solve for 25% (x) = 40 , where x is proportion of bonds in “total” portfolio. which is 160% FC portfolio is bonds ofcourse best we can do is 100. So best feasible answer in my opinion is FC asset allocation to be 100 percent in bonds. That is my opinion given how i have approached it.

The CFAI answer advises 35% in bonds. Which would suggest a .25 (35) = 8.75 % bonds (91% equity) in total portfolio. This seems a bit too extreme for me… especially for a moderate risk investor.

Finally the answer goes on to say a greater proportion of the investores wealth in Fc should be allocated to risk free asset over time. This seems to counter intutive. If i recall correctly from reading. IF an investors HC is stock like. invest primarily in bonds for FC and as Fc increases over time, scale down allocation to bonds and give more weight to equity.

Anyone can guide me here.

bump

• look at the exhibit 9 for a 35 year old investor … 65 Stock + 35 Bonds comes directly from there.
• There are pretty much no calculations involved or required to be done here.
• Here his current HC is equity like. As he grows older his HC would reduce - but if you had a 100% bond FC like you have taken - the ending position at retirement would be all bond like and would run the risk that the total wealth would not be high enough. Additionally given bonds earn much lower - you would not have enough FC collected either.
• So you need some equity now. That is the rationale.
• And that chart seems to be what arrives at the magic 65-35 number.

Cpk,

1. if by exhibit 9, do you mean figure 9. I see that, are we supposed to rote learn these percentages?

2. His fc is reletively small as he is reletively young. and majority of portfolio (hc) is equity. The ending position at retirement would not be all bond like because… over time as your fc increases and hc decreases you are supposed to scale down your bond allocation in fc.

3. for sake of argument if we agree we still need some equity, atleast dominant allocation or majority of allocation should be bond. here even that is not true and he is allocation 65% stock and 35% bonds.

4. given the general prinicple for sake of argument that we need some equity, how do we arrive at the precise number in choosing from other availible options e.g 20 percent equity or 65 percent equity for example>?

yes I meant figure 9.

for your point 2) if your current fc is all BOND - and you expect to scale it down while the individual grows - that would defeat the purpose. If you looked at Part 1 of the question - the other investor had a high bond like hc - and therefore you go ahead and invest the fc completely into equity. Over time - the FC grows - so more equity, while HC comes down - so the two balance each other.

Here HC is all equity like. Making a 100% bond like FC investment - has two issues - 1) bonds have a lower growth rate. 2) HC is going to come down as investor ages - so the Equity part is not present as much in the portfolio at retirement. So more of FC should be Equity – > 50% definitely - since HC would reduce and the proportion of risk free assets in the FC would be going up due to growth there, while the HC is declining.

Now as to how to arrive at the precise numbers - the chart seems to be the only thing - based on past results.

not sure really how to go and arrive at the precise numbers…

cp

proportion of risk free assets in the FC would be going up due to growth there. why would that be the case…

in the reading it says if your hc is, equity like. you invest more in bonds in your fc but also scale down your allocation in bonds and more towards equity… over time… because fc is increasing and hc is decreasing and so fc is becoming bigger chunk of portfolio. so shoudn it be the case that proportion of risk free assets in the fc should be decreasing???

• if the FC is 100% bonds - it is not going to become equity all of a sudden.
• they also do not talk about scaling down anything in the entire reading. They talk of the proportions changing due to the effect of the growth portions. If for proportions changing - you are thinking that they are going to change the investment portfolio entirely as they grow older - that I do not think is mentioned / indicated in the reading. It is the natural growth of the FC – due to growth component and the HC declining (due to PV(Future income) going down as the investor ages.

scaling down is due to the natural attrition (wearing down) of HC and the natural growth portion of the FC.

cp “i think” the reading does say you need to change your fc asset allocation over time, as a reaction to the fact that your asset allocation is being changed from what you originally set becauce fc itself is increasing and hc is decreasing. so ur allocation to your total portfolio (fc+hc) is changing. you need to counter the effect that this change has…

i will get back to you on this tommrow, when i get hold of the reading…

hey guys,

What do you think about the next question (3)? Lee’s situation is very similar (if not identcicl) to Wu’s. But the recommended portoflio for him is B. Hi is also 35 years old and has a high correlation with risky assets. Do you see any differences that would justify a different allocation for him? THX!

Absolutely anettsz, I am having the same problem. Not able to understand why there is a different allocation

that makes two uf us anybody else?

hi,

I submitted the question to the cfa institute and received the following answer:

the text is correct as written. There are distinctions between Wu and Lee: Lee’s income is higher. Wu’s income is highly correlated to risky asset returns and Lee’s exhibits a correlation of 0.90 to the performance of the S&P 500. The allocation is affected by the correlation of income to risky assets; both are less heavily invested in stocks than someone of this age with similar but steadier income. However, behavioral factors (Lee is an equity trader and will feel he knows stocks; also, an equity trader is likely to have a relatively high degree of risk tolerance) and the higher income compared with Wu result in a heavier weighting in stocks for Lee.

What do you think?

Well, yeah… it did not convince me either… The salary of 200 T or 175 T USD could make such a difference to portfolio allocation? Both of them have high correlations with risky assets (one: risky assets, the other: specifically, S& P). Again, the difference in their occupation… stockbroker or equity trade… come’on… this is just the same category.

As clear as mud I must say!!

I found some questions where they use arbitrary thoughts not mentioned in the question to derive “what they think is right”… I just hope my brain works the way CFA wants me to (only on June 1st though)!!!