excerpt from a 2004 L3 exam question: Maclin family with sizable inherited asset: age 40/38, with newborn baby twins; liquid asset = $1,285,000 (905,000 in cash, the rest in stocks or bonds); annual income = $80,000, tax = 40% => $48,000 after-tax; annual expenses = $74,000 (after-tax salary increases will offset any future increases in expenses); willingness to take risk: no more than 12% loss in any given year. Answer: overall risk tolerance is below average dominated by their below-average willingness. my question is: Is -12% per year or -1% per month really a below-average risk budget or indeed an average risk budget? Is there any kind of benchmark we can use for this type of questions?
I thought -10% per year is average, then -12% is below average.
I don’t think that 12% loss is below average willingness. But I believe if you apply the “Life cycle investing SS” guidelines you come up with below average risk tolerance based on ability. You have to determine the net discretionary wealth relative to liabilities. This couple fits the “Not wealthy” category. Long time till retirement, unable to save from salary, baby twins ( liabilities) … The recommended risk tolerance in this case is “conservative”.
the answer actually says the couple’s risk taking ability is average but willingness is below average. so, willingness prevails in setting up risk objective of IPS. to be honest, i felt hopeless on these type of questions, but for sure, we have to face them big time in our coming exam.
have done a lot of practice questions in which the investor/foundation had a max downside deviation of 10% - and the answer was still average or above average risk tolerance How does 12% max then automatically indicate below average willingness? Especially since that would be more than 2 standard deviations below a lot risk/return combos. I read the question, and here’s the exact answer to willingness: “The Maclins have a below-average willingness to take risk, based on their unhappiness with the portfolio volatility in recent years and their desire not to experience shortfall risk in excess of –12 percent return in any one year in the value of the investment portfolio.” I refuse to believe that a 12% max downside alone indicates a below average willingness. Otherwise, we’ve been lied to on the other sample questions. Still, I would have put average willingness and above average ability.
mo34 Wrote: ------------------------------------------------------- > I don’t think that 12% loss is below average > willingness. > > But I believe if you apply the “Life cycle > investing SS” guidelines you come up with below > average risk tolerance based on ability. > > You have to determine the net discretionary > wealth relative to liabilities. This couple fits > the “Not wealthy” category. Long time till > retirement, unable to save from salary, baby twins > ( liabilities) … The recommended risk tolerance > in this case is “conservative”. Actually dude, the answer is average ability. “Ability: The Maclins have an average ability to take risk. While their large asset base and a long time horizon would otherwise suggest an above-average ability to take risk, their living expenses (£74,000) are significantly higher than Christopher’s after-tax salary (£48,000) causing them to be very dependent on projected portfolio returns to cover the difference and thereby reducing their ability to take risk”
> Actually dude, the answer is average ability. I have not seen the question or the answer, I’m trying to suggest a systematic way to determine the ability.
“based on their unhappiness with the portfolio volatility in recent years” what does the problem mention about this at the begining? perhaps everybody is focusing on this -12% and the problem is that they experienced a substantial loss in the past (which is what is pushing down willingness now)
what stated in original question is “they have been unhappy with the portfolio volatility they have experienced in recent years. they state that they do not want to experience a loss in portfolio value greater than 12% in any one year.”
tanyusha Wrote: ------------------------------------------------------- > I thought -10% per year is average, then -12% is > below average. Hmmm… I like about 1% daily 95% VaR = daily sigma = 1/1.96 = 0.5 so yearly I get Sqrt(250)*0.5 = 8% vol so down 12% is a 1.5 sigma event. That sounds about right for me. But if -10% risk tolerance is average than -12% risk tolerance would be above average.
shouldn’t 5% VaR be 1/1.65? but, it wont change your conclusion
Yeah probably
I am lost… I would also think that if -10% risk tolerance is average than -12% risk tolerance would be above average. JoeyDVivre , How should I knw that this is below average willingness?
both -10% (Ingers case) and -12% (Maclin case) is below average willingness it’s hard to understand, just need to remember