16 May midnight study
https://chatgpt.com/c/fdae4664-c2f1-4bc1-8569-6ef93c82f8fc
Emma Young, a 47-year-old single mother of two daughters, ages 7 and 10, recently sold a business for $5.5 million net of taxes and put the proceeds into a money market account. Her other assets include a tax-deferred retirement account worth $3.0 million, a $500,000 after-tax account designated for her daughters’ education, a $400,000 after-tax account for unexpected needs, and her home, which she owns outright.
Her living expenses are fully covered by her job. Young wants to retire in 15 years and to fund her retirement from existing assets. An orphan at eight who experienced childhood financial hardships, she places a high priority on retirement security and wants to avoid losing money in any of her three accounts.
QuestionQ.Identify the behavioral biases Young is most likely exhibiting. Justify each response.
Bias
Justification
Loss Aversion
Under loss-aversion bias, people strongly prefer avoiding losses as opposed to achieving gains and they assign a greater weight to potential negative outcomes than positive ones. Young’s strong emphasis on retirement security and her desire to avoid losing money indicates that she has a loss-aversion bias. This bias could interfere with her willingness to maintain ideal asset allocations during times of negative returns. Emma places a high priority on retirement security and wants to avoid losing money in any of her accounts. Loss aversion describes the tendency to prefer avoiding losses over acquiring equivalent gains. Emma's fear of financial loss, likely stemming from her childhood financial hardships, makes her extremely cautious about any potential losses, even if it means sacrificing higher potential returns.
Illusion of Control
Mental Accounting
Under mental accounting bias, people treat one sum of money differently from another sum based solely on the mental account to which the money is assigned. Young is considering her $3 million tax-deferred retirement account, her $500,000 account for the girls’ education, and the $400,000 emergency account separately, rather than seeing them all as a combined investable total. In doing this, she sets herself up for the possibility of sub-optimal allocation. Emma’s decision to separate her assets into distinct accounts for specific purposes (retirement, daughters' education, unexpected needs) is a clear example of mental accounting. This bias involves treating money differently depending on its source or intended use, rather than considering it as part of a total wealth picture.
Representative Bias
Framing Bias
Availability Bias
Under availability bias, people take a mental shortcut when estimating the probability of an outcome based on how easily the outcome comes to mind. Easily recalled outcomes are often perceived as being more likely than those that are harder to recall or understand. Young’s strong emphasis on retirement security and her desire to avoid losing money both could be driven by her strong memories of her childhood financial hardships. Given her past financial hardships, Emma might disproportionately weigh recent or easily recalled events in her decision-making process. Availability bias occurs when individuals rely heavily on immediate examples that come to mind. Her childhood experiences could overly influence her current financial behavior, making her more risk-averse.
Q.
A broker proposes to Young three portfolios, shown in Exhibit 1. The broker also provides Young with asset class estimated returns and portfolio standard deviations in Exhibit 2 and Exhibit 3, respectively. The broker notes that there is a $500,000 minimum investment requirement for alternative assets. Finally, because the funds in the money market account are readily investible, the broker suggests using that account only for this initial investment round.
Exhibit 1:
Proposed Portfolios
Asset Class
Portfolio 1
Portfolio 2
Portfolio 3
Municipal Bonds
5%
35%
30%
Small-Cap Equities
50%
10%
35%
Large-Cap Equities
35%
50%
35%
Private Equity
10%
5%
0%
Total
100%
100%
100%
Exhibit 2:
Asset Class Pre-Tax Returns
Asset Class
Pre-Tax Return
Municipal Bonds
3%
Small-Cap Equities
12%
Large-Cap Equities
10%
Private Equity
25%
Exhibit 3:
Portfolio Standard Deviations
Proposed Portfolio
Post-Tax Standard Deviation
Portfolio 1
28.2%
Portfolio 2
16.3%
Portfolio 3
15.5%
Young wants to earn at least 6.0% after tax per year, without taking on additional incremental risk. Young’s capital gains and overall tax rate is 25%.
Determine which proposed portfolio most closely meets Young’s desired objectives. Justify your response.
Portfolio 1
Portfolio 2
Portfolio 3
Justify your response.
Your Answer:Portfolio 3, having post-tax return of 0.0645, with lowest post-tax standard deviation
Solution
Determine which proposed portfolio most closely meets Young’s desired objectives. (Circle one.)
Portfolio 1
Portfolio 2
Portfolio 3
Justify your response.
Portfolio 3 comes closest to meeting Young’s desire to earn at least 6% after tax per year without taking on additional incremental risk. Portfolio 3 offers a lower standard deviation than Portfolio 2, as summarized in Exhibit 3, while producing approximately the same return. Portfolio 1 achieves the highest returns but at a much greater level of volatility than Portfolio 3, not satisfying Young’s risk criterion. Given the $500,000 minimum investment requirement for alternative assets, at Young’s total portfolio size of $5.5 million, the suggested 5% allocation to private equity in Portfolio 2 results in only a $275,000 exposure, insufficient to invest in private equity. Thus, Portfolio 2, as presented, is not viable,
whereas Portfolio 1, with a private equity investment of $550,000, meets the minimum requirement for alternative investments.
This minimum investment requirement is not an issue for Portfolio 3 because it has no private equity component.
Asset Class
Portfolio 3
Pre-Tax Return
Post-Tax Return
Resulting Return
Municipal Bonds
30%
3%
3.00%
0.90%
Small-Cap Equities
35%
12%
9.00%
3.15%
Large-Cap Equities
35%
10%
7.50%
2.63%
Private Equity
0%
25%
18.75%
0.00%
Total
100%
6.68%
Q.
A broker proposes to Young three portfolios, shown in Exhibit 1. The broker also provides Young with asset class estimated returns and portfolio standard deviations in Exhibit 2 and Exhibit 3, respectively. The broker notes that there is a $500,000 minimum investment requirement for alternative assets. Finally, because the funds in the money market account are readily investible, the broker suggests using that account only for this initial investment round.
Exhibit 1:
Proposed Portfolios
Asset Class
Portfolio 1
Portfolio 2
Portfolio 3
Municipal Bonds
5%
35%
30%
Small-Cap Equities
50%
10%
35%
Large-Cap Equities
35%
50%
35%
Private Equity
10%
5%
0%
Total
100%
100%
100%
Exhibit 2:
Asset Class Pre-Tax Returns
Asset Class
Pre-Tax Return
Municipal Bonds
3%
Small-Cap Equities
12%
Large-Cap Equities
10%
Private Equity
25%
Exhibit 3:
Portfolio Standard Deviations
Proposed Portfolio
Post-Tax Standard Deviation
Portfolio 1
28.2%
Portfolio 2
16.3%
Portfolio 3
15.5%
Young wants to earn at least 6.0% after tax per year, without taking on additional incremental risk. Young’s capital gains and overall tax rate is 25%.
Determine which proposed portfolio most closely meets Young’s desired objectives. Justify your response.
Portfolio 3 comes closest to meeting Young’s desire to earn at least 6% after tax per year without taking on additional incremental risk. Portfolio 3 offers a lower standard deviation than Portfolio 2, as summarized in Exhibit 3, while producing approximately the same return. Portfolio 1 achieves the highest returns but at a much greater level of volatility than Portfolio 3, not satisfying Young’s risk criterion. Given the $500,000 minimum investment requirement for alternative assets, at Young’s total portfolio size of $5.5 million, the suggested 5% allocation to private equity in Portfolio 2 results in only a $275,000 exposure, insufficient to invest in private equity. Thus, Portfolio 2, as presented, is not viable, whereas Portfolio 1, with a private equity investment of $550,000, meets the minimum requirement for alternative investments. This minimum investment requirement is not an issue for Portfolio 3 because it has no private equity component.
Q.
The broker suggests that Young rebalance her $5.5 million money market account and the $3.0 million tax-deferred retirement account periodically in order to maintain their targeted allocations. The broker proposes the same risk profile for the equity positions with two potential target equity allocations and rebalancing ranges for the two accounts as follows:
Alternative 1: 80% equities +/– 8.0% rebalancing range
Alternative 2: 75% equities +/– 10.7% rebalancing range
Determine which alternative best fits each account. Justify each selection.
Account
Alternative
Justify each selection.
$5.5 Million Account
Alternative 1 Alternative 2
$3.0 Million Account
Alternative 1 Alternative 2
Your Answer:5.5 mil acc on alternative 2 3.0 mil acc - alternative 1
Solution
Account
Alternative
Justify each selection.
$5.5 Million Account
Alternative 2
The $5.5 million account is after tax. Because after-tax volatility is lower than pre-tax volatility, the rebalancing range for an after-tax account is wider. The range reflected for Alternative 2 is 10.7%, whereas the range for Alternative 1 is 8.0% (to achieve the same risk constraint), reflecting the impact of taxes on the $5.5 million account. In addition, asset sales in the after-tax account result in taxes due. A wider target range allows more price movement before the rebalancing range is exceeded (and a decision must be made to initiate an asset sale, incur associated tax payments, and rebalance back to the target equity allocation). The after-tax account range is calculated by adjusting the pre-tax range for taxes. After-tax rebalancing range = Pre-tax rebalancing range/(1 – Tax rate). 8.0%/(1 – 0.25) 10.67%
$3.0 Million Account
Alternative 1
The $3.0 million is a tax-deferred retirement account. Because pre-tax volatility is higher than after-tax volatility, the rebalancing range for a pre-tax account is narrower. The range reflected for Alternative 1 is 8.0%, whereas the range for Alternative 2 is 10.7% (to achieve the same risk constraint), reflecting the impact of tax deferral on the $3.0 million account versus the effect of taxes on the $5.5 million account.
Ten years later, Young is considering an early-retirement package offer. The package would provide continuing salary and benefits for three years. The broker recommends a special review of Young’s financial plan to assess potential changes to the existing allocation strategy.
Identify the primary reason for the broker’s reassessment of Young’s circumstances. Justify your response.
Change in goals
Change in constraints
Change in beliefs
Justify your response.
Q.
Ten years later, Young is considering an early-retirement package offer. The package would provide continuing salary and benefits for three years. The broker recommends a special review of Young’s financial plan to assess potential changes to the existing allocation strategy.
Identify the primary reason for the broker’s reassessment of Young’s circumstances. Justify your response.
Change in goals
Change in constraints
Change in beliefs
Justify your response.
Your Answer:change in constraints. There's 2 years (15 - 10 - 3 = 2) not having income as supposed to
Solution
Identify the primary reason for the broker’s reassessment of Young’s circumstances. (Circle one.)
Change in goals
Change in constraints
Change in beliefs
Justify your response.
A change in constraints relates to material changes in constraints, such as time horizon, liquidity needs, asset size, and regulatory or other external constraints. In this case, Young’s circumstances have changed; she is considering accepting the offer and retiring five years sooner than she originally anticipated. A change in an investor’s personal circumstances that may alter her risk appetite or risk capacity is considered to be a change in goals. In this circumstance, Young’s risk appetite or risk capacity have not changed, whereas the time horizon associated with her goals has. A change in the investment beliefs or principles guiding an investor’s investment activities is considered to be a change in beliefs. In this circumstance, Young’s guiding principles have not changed.
Young decides to accept the retirement offer. Having very low liquidity needs, she wants to save part of the retirement payout for unforeseen costs that might occur more than a decade in the future. The broker’s view on long-term stock market prospects is positive and recommends additional equity investment.
Q.
Young decides to accept the retirement offer. Having very low liquidity needs, she wants to save part of the retirement payout for unforeseen costs that might occur more than a decade in the future. The broker’s view on long term stock market prospects is positive and recommends additional equity investment.
Determine which of Young’s accounts (education, retirement, reallocated money market, or unexpected needs) is best suited for implementing the broker’s recommendation.
Account
Justification
Education
Reallocated Money Market
Retirement
Unexpected Needs
Your Answer:reallocated money market instead coz after 10 years, education left few years to go for her 7, & 10 yr-old childrens retirement is within 5 years unexpected needs is unexpected so only reallocated money market suitable
Solution
Determine which of Young’s accounts is best suited for implementing the broker’s recommendation. (Circle one.)
Account
Justification
Education
Reallocated Money Market
As a general rule, the portion of a taxable asset owner’s assets that is eligible for lower tax rates and deferred capital gains tax treatment should first be allocated to the investor’s taxable accounts.
Equities should generally be held in taxable accounts, whereas taxable bonds and high turnover trading strategies should generally be located in tax-exempt and tax-deferred accounts. The reallocated money market account is a taxable account, whereas the retirement account is tax-deferred.
The unexpected needs account requires liquidity (in case of unexpected needs), so it is better suited for shorter-term positions. Given the ages of Young’s two daughters, now 17 and 20, the education account is most likely currently funding college expenses and will be for the next several years. Accordingly, it needs to be invested in highly liquid assets to cover these costs.
Retirement
Unexpected Needs
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