Risk Tolerance and Time Horizon Frustrations - Very Opinionated/Vague

CFA Level II
#1

I’m having diffiiculty assessing risk tolerance and time horizon presented during some mock exams. I know these questions seem (and should be EASY points) but I feel they are very opionated and vague. Can someone please help me stop overthinking these? I get them sometimes but other times I don’t. If I’m going to miss a question on the exam, I want it to be a hard one not one I feel should be easy.

For example… I was asked to “describe a woman’s post-retirement RISK TOLERANCE” & then to assess her " TIME HORIZON"

Details provided:

  • 56 years old (single; husband died several years back)
  • Excellent Health
  • Plans to retire in 5 years
  • During retirement - Wants to travel and spend time with grandchildren
  • Only signifcant asset is her 401K
  • Her salary is adequate to cover expenses until retires in 5 years
  • Does NOT anticiapte to accumulate any additional savings other than 401k
  • Current 401K balance is $3.2 M (estimated to be worth $4.5M by time she retires)
  • During retirement , she expects her living expenses to be $150,000 per year (includes travel budget)

The ANSWER provided says that her risk tolerance POST-retirement is ABOVE AVERAGE??? Can someone explain to me how this is possible?? Per the curriculum, I understand that risk tolerance is a component of both williness and ability. I just feel that this could be looked at 2 ways… I mean how long do they anticipate this lady living?? Also there is nothing in the question saying she wants to leave funds for grandchildren/trust??? How much money does a person need!!! (again it’s an opinion based answer in my OPINION!!!)

Opinion #1 - With substantial asset value in her 401K (expected to be above $4M) she has the ability (even after retiring) to take substantial risk/above average.

Opinion #2 : Why would she take above average risk (risking the principal of her only asset post-retirement) when below average risk would still probably provide some investment income with little to no risk of principal. She can’t take it to the grave with her and there is nothing mentioning that she wants to leave it to grandchildren/trust fund. Based on her post retirement expenses and current/expected 401k balance, it should last her 25-30 years…

As for time horizon, the answer is saying " Long-term and MULTISTAGE"

Again, I feel this is based on an opinion of how long she will live (ST/LT). Also, can someone please explain the difference between Single Stage and Multistage. I feel like every answer I have seen is multistage…

Any insight is much appreciated!!! I can’t wait until this week is OVER!!! smiley

#2

The quick and dirty explanation I’ve been operating under is when willingness and ability are aligned (above average or below average), then your answer is clear with respect to risk tolerance.

For those with above average ability/below average willingness (or vice versa), “education” or “resolution” is needed for the client, according to the curriculum.

Of course how you define those terms is probably getting more to your point. Stages are going to be easier because they flow from time horizon. And if the time horizon includes retirement, college, more mouths to feed, etc, that will almost always indicate multi-stage. Really anything that a vignette defines as having a wealth-accumulation phase and a wealth-usage phase would be more than one stage. The only times I could think of a one-stager would be if they were already retired or the time horizon was short (perhaps for a particular purchase or something).

I think the vignette made it clear that she had an above average willingness to take risk. As far as ability to take risk, they give you enough to make a pretty solid determination as you state that she could live on her money forever with pretty meager returns.

As for why she would actually take on the risk when she doesn’t have to isn’t really what the question asked (and really what the portfolio manager would tend to explain). Perhaps she has a high risk tolerance because she wants to leave behind a larger nest egg to charity or grandkids and wants a higher return. There’s all sorts of armchair psychology we won’t accomplish in three minutes during Saturday’s exam, so I would stick with refraining from introducing too many unstated assumptions and go with what she could do versus what she ought to do.

But yes, these kinds of questions are irksome to me too.

#3

Thank you!! That makes sense especially your explanation on the stages!