Couple 30 years old, both are unemployed and live off the income from their inheritance. They require 5% real return a year to survive. Time horizon 30 years. What is their risk tolerance? I cant get it straight, does long time horizon implies that they can take on more risk or does the fact that they need 5% implies that they can take on less risk 
Using CFAI textā¦ Ability===>Above average, determined by time horizon. 30 years. Willingess==> Since it is inheritance, less understanding of risk, āimpliedā that below average risk. Unemployment is also a contributing factor too. Honor the lower one===>Below average. However, I could be completely wrong!!!
I would almost say that being unemployed would be the overriding factor in this case. Ability is average to below-average (long horizon; need 5% real return (so probably 8%+ nominal pre-tax return); unemployed so they rely solely on portfolio performance for income) Willingness is probably below average (inheritance usually means less knowledge of risk) Overall, Iād say below-average tolerance but you could definitely argue for average. I donāt think above-average should be considered. Was this in the CFAI text? I donāt remember seeing it.
^Sorryā¦I used CFAI text too broadlyā¦I guess.
Can anyone tell me how do one quantify the required return threshold for below-average, average or above-average risk-taking ability ? Are there magic numbers(that I somehow missed in the CFA texts) or you go by what you *feel* in achievable by taking below-average, average or above-average risk ?
That is exactly my problem, i cant really say!
Let me ātryā to attempt thatā¦I believe the ācutoffā line is 4%ā¦that counts as low rate of return.
I believe I either read or was told by an instructor that over 7% starts to run the risk of eroding principal so that would be below average. Less than 5% is probably safe for most investment strategies (in the long run) so that is above average. From 5% to 7% is usually average. But the ārealā question is: real or nominal?, before or after tax? If someoneās real required return is 3.5% but inflation is 3% and taxes are 30%, there nominal pre-tax return is (3.5% + 3%)/0.70 = 9.28%. Is that still considered low?
I would argue for a low risk tolerance based on inherited money (which in CFA-land implies lower risk tolerance), no income and thus no savings cash flow to replenish losses and the fact this inheritance is their sole source of sustenance. The time horizon is a confounding factor, though, for sure. If there is a ālow-to-moderate riskā answer, Iād go with that one. Well, I hope this lazy couple can get off the sofa and get a job within 30 years!..assuming ability, of course. And no, fsa-sucker, there really arenāt any threshold numbers in the CFA text we can use. In practice, of course, virtually every planning firm will have some variation of a risk-tolerance questionnaire with a scoring system and pretty little risk-profile boxes to put you in. Anyway, Iām definitely getting that the L3 exam questions will be much more based on judgement and justification rather than the right/wrong questions and calculations of L1 and L2 that weāve all come to love and cherish.
i guess one needs to consider how flexiable this 5% is. can this couple survive without this 5% at any given year (assume they dont plan to drawdown their principal)? if answer is no, then donāt apply large tracking error to this benchmark. so, risk tolerance has to be conservative. one can be categorized as below-average with 20% return goal but close-to-zero-appetite for risk (such as gmās pension); while another one can be categorized as above-average with 5% return goal but big room for risk (such as bill & melinda gates fundation).
Patacon Wrote: > > justification rather than the right/wrong > questions and calculations of L1 and L2 that weāve > all come to love and cherish. Ahhhā¦those good old days.
fsa-sucker Wrote: ------------------------------------------------------- > Can anyone tell me how do one quantify the > required return threshold for below-average, > average or above-average risk-taking ability ? Are > there magic numbers(that I somehow missed in the > CFA texts) or you go by what you *feel* in > achievable by taking below-average, average or > above-average risk ? I believe you should consider the net worth/Liabilities situation when deciding on the risk tolerance. If negative net worth (PV of future Liabilities > discretionary Assets) or small (net worth / Liabilities), plus, unable to save from employment (unemployed in this case), then select below average. Time span is irrelevant in this case ( I guess).
I would hazard to guess that the ability to take on risk is above avg due to: 1.) Long time horizon (30 yrs) 2.) Young 3.) relatively low return requirements I would also agree with ws that the willingness to take on risk is low, due to the fact that wealth is from an inheritance.
CSK: Is there an answer/explanation from whatever source you got this question? Iām really curious how this is addressed. I need resolution!
Sorry dude, this was just a hypothetical question i came up with. It just shows that lines are very blurry and it is clear by CFAI answers. I hope that CFAI wont overlook well argumented answers
comp_sci_kid Wrote: ------------------------------------------------------- > I hope that CFAI wont overlook well argumented answers Ha! Thatās funny.
It would depend on total asset base and how much do they need to sustain themselves. E.g. if their inheritance is $10MM and their expenses are $100,000 a year, then 5% return requirement along with 30 year horizon gives them ample risk taking ability. However, if on the other hand, their inheritance is $1MM and their expenses are $50,000, their risk taking ability is greatly reduced - no equities for these guys.