Reading 14 EOC question 3

Q 3 on page364, R 14. For Lee (equty trader) isnt the allocation B wrong? I think it should be allocation D, since the high correlation with SP500 of 0.9.Thanks

This question is pretty awful, if only because of the question immediately preceeding it…

The question before had a 35 year old stockbroker making $175,000 a year and they gave him a 65 stock / 35 bond portfolio. Ok, makes sense.

This question says Lee is a 35 year old equity trader making $200,000 a year and gives him 80 stock / 20 bond.

Why the hell would they treat these two differently? what is the cutoff for a 80/20 and 65/35 portfolio. Honestly this is really weak.

Asumming that a young 35years old professional is making a considerable income of 175 000+ you can consider that you will be heavily invested in stock. ( figure 13 page 349 )

But Steve has 1 250 000$ in the bank. that is alot of financial assets compare to his human capital assets. So putting him in a less risky portfolio make sense.

we dont have any information about Lee’s financial wealth. so i assume he has little or none. With his age and salary he can easily go to 100% stocks. Since his income his 0.9 correlation with the stock market, you can de-risk his portfolio a little bit and bring it to 80/20.

conclusion : Steve has much more money invested in stock ( even if he is 65/35) than lee ( since he has little financial wealth to invest )

answer looks OK to me.

Oh also, 3 questions later - question 6…

They discuss a 23 year old guy in the financial services industry and the answer states this:

"Young investors with equity-like human capital should be invested predominantly in fixed-income assets".

Wow. Really? So in questions 2 and 3 the CFA society said 35 year olds in the financial services industry should have either 65/35 or 80/20 stock/bond allocations (of course not stating the difference why, but no matter) - now it is PREDOMINANTLY IN FIXED-INCOME ASSETS?

_ I am about to explode with rage at their horrific contradictions… _

Do me a favor - compare Wu from question 2, Lee from question 3, and Tom from question 6. Then tell me the CFA Society isn’t trying to make my life hell by contradicting itself…

Wu Q2: 35 yr old, Stockbroker 175K income, high correlation with risky assets

High correlation with risky assets - therefore he needs a lower allocation with riskier stocks.

They seem to directly take the number off from the Figure 9 - Scenario 1 - The grey highlighted bar - where a 35 year old has a 35% allocation to risk free asset. So 65/35 to Stocks/Bonds.

Lee Q3:35 yr old, Equity trader, 200K income, 0.9 correlation with S&P500

This seems to be taken directly from Figure 11 - where at 0.90 correlation - the optimal allocation to risk free asset is 20%.

Tom Q6:Sampson 23 year old, just starting his career in financial services industry as a stockbroker, 35K annual income.

This is definitely easier than the other two - I think. Sampson is young, but his human capital is highly correlated with the stock market. It is risky as well - so a higher return would be attached with it, which would make the PV(Human Capital) a low number. So no Life insurance, and no equities. IT has to be bonds.

just remeber that :

An investor’s human capital can be viewed as “stocklike” if both the correlation to the financial markets and its volatility are high. It can be viewed as “bondlike” if both correlation to the financial markets and volatility are low. Initially, for a younger investor, if financial wealth is limited and human capital is “bondlike”, it is appropriate to invest financial wealth predominantly in risky assets. As this investor’s financial wealth increases relative to human capital (i.e., financial wealth increasingly dominates total wealth), a greater portion of financial wealth should be invested in the risk-free asset. For a younger investor, if financial wealth is limited and human capital is “stocklike”, a greater portion of financial wealth should be invested in the risk-free asset. As this investor’s financial wealth increases relative to human capital, a greater portion of financial wealth should be invested in the risky asset.

(Institute 368)

Institute, CFA. Level III 2013 Volume 2 Behavioral Finance, Individual Investors, and Institutional Investors. John Wiley & Sons P&T, 6/18/2012. page(368)

Nancy’s portfolio should be more invested towards stock than Wu ( because wu has corelation to the markets )

hernandez should be less invested in stocks than lee ( because hernandez has alot of financial wealth )

Tom FINANCIAL assets( since it says recommended investment, not total portfolio ) would be invested in bonds ( since he has equity like income but overall his total portfolio would be tilted towards stocks since his human capital is invested in stock )

I think you worry too much about the difference between LEE and WU. the only reason why I see that LEE is more invested toward stocks is because of his higher Income. Ultimately you should know that Nancys should be more invested in stocks than Wu and LEE should be more invested in stocks than Steve.

hope this helps

how do you say Lee has a higher return?

sorry I meant income.

As you said, it can be that Wu income are “highly correlated to market returns” which may implied a correlation higher than 0.9.

as I said, i would not worry too much about it as long as you know that investor A should be more invested in stocks than investor B in X scenario

cannot buy that still. 0.9, 0.95 is a pretty high correlation either way.

does a 25K change in the income per year - make that huge a difference on asset allocation on the financial capital side?

also very strongly the fact that seems to keep driving me to the charts I indicated above is the use of the exact same numbers from there.

So is this two more charts to push into memory (that is already overloaded)?

the LOS is :

explain how asset allocation policy is influenced by the risk characteristics of human capital and the relative relationships of human capital, financial capital, and total wealth;

(Institute 323)

Institute, CFA. Level III 2013 Volume 2 Behavioral Finance, Individual Investors, and Institutional Investors. John Wiley & Sons P&T, 6/18/2012.

So no. I would defenetly not learn by heart those charts.

just so you know CPK. if you look at page 336, those are the formula to extract the exact asset allocation. You dont have all the information to use this formula. if the LOS was CALCULATE instead of EXPLAIN i would have learned those formula.

you need variable like life expectancy, coefficient of risk aversion, total human capital, financial capital… etc etc

and yes 25 can make a difference on the TOTAL human capital considering its a annuity

Thanks to both. My problem is the CFA answer to question 6 " “Young investors with equity-like human capital should be invested predominantly in fixed-income assets”.

Especially after seeing the other 2 portfolios for Lee and Wu (which are both supposed to be majority stocks) - they then state that Tom should have predominantly fixed-income assets even after they state that 35 year olds (12 years older than Tom) making more money, also in the financial industry, should have a majority of their portfolio in stocks.

It doesn’t pass the commom sense test at all. I knew that Tom’s portfolio should be more in stocks than bonds after seeing Lee and Wu, and yet they mention the quote above and that doesn’t jive at all.

you need to understand that PORTFOLIO is financial assets ( savings ) and Human Capital ( salary)

when your a young, pretty much all of your portfolio is human capital so you dont have direct investment in stocks. if you have available savings, you put it in Fixed income.

ex : you present value of future salary is 1 000 000$ and you have 100 000$ in savings.

if you put 100% of your actual money ( savings ) in fixed income, your total portfolio asset mix is 91% stock, 9% fixed income.

question 2 and 3 is about TOTAL portfolio ( financial assets + human capital )

question 6 is about what INVESTMENT ( your savings ) should you chose.

I see. well, we’ll see what I come across in practice tests since I don’t have any other questions on the chapter I can do now. Thanks.

Wrong:

when your a young, pretty much all of your portfolio is human capital so you dont have direct investment in stocks. if you have available savings, you put it in Fixed income.

Portfolio vs investment, no, sorry… don’t see your point there.

Starting a post with the word wrong then quoting me doesnt make me want to help you

mahhhh let me try to clarify this since there is maybe other fellow AF ppl that this is still not clear.

first off :

  1. If you dont know the risk aversion coefficient of the person, there is no such thing as a perfect answer. With the risk aversion coefficent, you can use formula (2) page 336 to figure out the exact optimal portfolio allocation

  2. Human capital and Financial Wealth are 2 different things. If you dont know the difference by now, you should go back to your book

  3. Human capital has 3 possibiliy : It can be correlated to market or it can be like a risk free assets, if its risk free then the investor should invest in stock. If its correlated to market it should invest in bonds. Human capital can also be highly volatile but not correlated to financial markets. This scenario require investment in stock

Yes, there is a slight inconsistency in question 2 and 3. question 2 stipulate that wu is 35 and is highly correlated to risky assets. which may not be stock market. Also, it says that it has comparable Total wealth than Jhonson, which you dont know the exact amount. You also dont know the risk aversion factor so the only thing you can be sure is that WU should have a less risky total portfolio than Jhonson.

Question 3 put emphasize on the total wealth factor. the more financial wealth you have compared to youe human capital, the more you should de-risk your portfolio. You still dont know the risk aversion factor of Lee so you cant really compare Lee and Wu even if they look similar. this is 2 seperate questions that put emphasize on different concept. one is risky human capital vs not risky and the other one is High financial wealth vs low financial wealth.

now, about question 6. Like I said. Tom has no financial wealth ( no money to invest ) and his human capital is stock like. Knowing those 2 facts, you know that is current portfolio is 100% stock 0% fixed income.

So when Tom have money to set aside, what should he invest in. well since his human capital is fully exposed to stock you know that is total portfolio should not be 100% stock 0% fixed income. it should be around 10-25% fixed income. you dont know is risk tolerance coefficent so you have no clue about the OPTIMAL allocation, but you know he should put is money in bonds when he has some available so his TOTAL portfolio ( human cap + financial CAP ) goes toward 80% stock 20% fixed income.

if this q comes in the CFA exam , I see many arguments with CFA , and possibly about 116 people contesting results and gaining a pass after having failed first time crying

Apol’s summer side, letting my frustration with cfa get the better of me.