18 May night study

Risk Tolerance	In the past, she has had a tendency to sell winning investments to avoid the risk of giving back gains. She also has had a tendency to retain losing investments even when there is little chance of them recovering in value.

The behavioral bias that Lennon’s past investment experience illustrates is best described as:

1. A.self-control bias.

2. B.mental accounting bias.

3. C.loss-aversion bias.

Solution

C is correct. The behavioral bias illustrated in Lennon’s past investment experience was loss-aversion bias: Losses are perceived as more painful than the satisfaction of equivalent gains, and assets that have incurred losses but have little chance of recovery are retained because the pain of recognizing the loss is too great. Given the risk of having to give back gains already realized, winning investments are often sold early, resulting in self-imposed limited upside potential.

A is incorrect. Self-control bias is a bias in which people fail to act in pursuit of their long-term, overarching goals because of lack of discipline. Lennon does not appear to exhibit this bias because she has taken steps to deal with her specific goals, including saving for her own future and that of her children.

B is incorrect. The mental accounting bias involves setting up separate accounts or buckets for wealth, each with its own risk tolerance and expected return depending on the purpose the investor associates with it. Although one of Fox’s comments refers to taking higher risk to achieve one of the goals, this is not being referred to in Exhibit 1, which deals with retaining losers and selling winners.

Asset Allocation with Real-World Constraints Learning Outcome

1. Identify and evaluate an individual’s behavioral biases

Other general comments were noted about asset classes, but Fox could not recall their sources:

• Emerging market equities should not be considered a separate asset class from global equities.

• Asset classes differ from strategies in offering a non–skill-based ex ante expected return premium.

• Asset classes should be defined in such a way that there is no overlap in sources of risk.

Question

In the general comments about asset classes that Fox noted, the most accurate comment is the one regarding:

1. A.the overlap of sources of risk.

2. B.emerging markets.

3. C.the return premiums from asset classes.

Solution

C is correct. Asset classes should have a return premium based on an underlying market risk factor (e.g., beta) and not any underlying skill of the investor. Strategies, on the other hand, involve combinations of asset classes with the objective of earning a return based on investment skill.

A is incorrect. There will be overlap of sources of risk when asset classes are defined, e.g., US and non-US equities, or even US small and large cap equities will have some risks in common, but there should be as few common risk factors as possible, and they should have only modest correlations.

B is incorrect. Emerging markets equities should be considered a distinct asset class as they differ from other equities in terms of diversification potential, informational efficiency, corporate governance, taxation, and currency convertibility.

Overview of Asset Allocation Learning Outcome

1. Explain the use of risk factors in asset allocation and their relation to traditional asset class–based approaches

Fox mentioned to the candidates that when dealing with strategic asset allocation, investors often had difficulty understanding the relevant characteristics of asset classes. They responded:

• Kelly: I like to stress to clients that asset classes should have high within-group correlations but low correlations with other classes. In addition, because investors need to rebalance to a strategic asset allocation, asset classes need to have both sufficient liquidity and low transaction costs.

• Trainor: It is important that asset classes should be diversifying. I always look for low pairwise correlations with other asset classes.

In the candidates’ responses to Fox regarding the relevant characteristics of asset classes, the statement that is least accurate is:

1. A.Kelly’s regarding correlations.

2. B.Trainor’s.

3. C.Kelly’s regarding rebalancing.

Solution

B is correct. Although Trainor is correct that asset classes should be diversifying, low pairwise correlations with other asset classes is not sufficient. An asset class may be highly correlated with some linear combination of the other asset classes even when pairwise correlations are not high. Both of Kelly’s comments are correct: Asset classes should have high within-group correlations but low correlations with other classes. If liquidity and transaction costs are unfavorable for an investment of a size meaningful for an investor, an asset class may not be a suitable investment for that investor.

A is incorrect. Kelly’s first comment is correct about both the within-group and between class correlations.

C is incorrect. Kelly’s second comment is correct. The criteria that he is referring to is that asset classes should have the capacity to absorb a meaningful proportion of an investor’s portfolio. He is correct in saying that if liquidity and transaction costs are unfavorable for an investment of a size meaningful for an investor, an asset class may not be a suitable investment for the investor.

Overview of Asset Allocation Learning Outcome

1. Explain the use of risk factors in asset allocation and their relation to traditional asset class–based approaches

Fox reminded the candidates that in addition to high-net-worth individuals, the firm’s client base also includes various institutional investors. The candidates made the following statements:

• Trainor: A goals-based approach to asset allocation is appropriate for individual investors, but institutions need to focus either on the asset or liability side of the balance sheet, depending on the nature of their business.

• Kelly: A typical objective of some institutions is to maximize their Sharpe ratio for an acceptable level of volatility, and they rely on the law of large numbers to assist them in modeling their liabilities. Other institutions behave much like individuals by segmenting general account assets into sub-portfolios associated with specific lines of business with their individual return objectives.

The most appropriate statement in regards to approaches to asset allocation by institutions is made by:

1. A.Kelly, regarding their goals-based allocations.

2. B.Trainor.

3. C.Kelly, regarding the Sharpe ratio and modeling of liabilities.

Solution

A is correct. Kelly’s second comment regarding institutions’ goals-based allocations is correct. Some institutions (e.g., insurance companies) segment their general account assets into sub-portfolios associated with specific lines of business or blocks of liabilities, with each sub-portfolio having its own return objective.

B is incorrect. Trainor is incorrect. Some institutions may focus on asset-only allocations, but another approach that can be used is liability-relative, which focuses on the assets in relation to the liabilities.

C is incorrect. Kelly’s first comment about the Sharpe ratio and the law of large numbers is incorrect. Institutions that maximize their Sharpe ratio for an acceptable level of volatility would be following an asset-only asset allocation approach, and, as such, they would not be concerned with modeling their liabilities.

Overview of Asset Allocation Learning Outcome

1. Compare the investment objectives of asset-only, liability-relative, and goals-based asset allocation approaches

Exhibit 1

Case Study of Jane Lennon

Name	Jane Lennon
Occupation and Family Structure	She is the morning news anchor for a national broadcasting company, where she has worked for the past 20 years. She is 56 years of age, divorced, and the sole supporter of her two children, Everett, aged 18, and Marshall, aged 14. Marshall suffers from severe medical and developmental issues.

Aspirational Goals and Extended Liabilities

Everett is just beginning university and plans to pursue a medical degree. Lennon plans on paying for his entire education and living expenses as well as providing some assistance in funding his future practice. She believes that these goals will be covered with $1.5 million in present value terms. She has begun the process of setting up a special needs trust to provide lifetime benefits for Marshall that will not interfere with the government benefits that he is eligible to receive. It will be funded with $2 million within the year. She recently received an honorary doctorate from her alma mater and has started the process of endowing a chair in its communications department. She anticipates that the funding will be made available to the university in two years; it has a present value of $1.75 million. The present value of future consumption is estimated to be $9 million.

Which of the sub-portfolios dedicated to Lennon’s aspirational goals is in the best position to tolerate the greatest risk exposure? The one dedicated to:

1. A. Everett’s education

2. B. Marshall’s trust

3. C. University endowment

Exhibit 1

Case Study of Jane Lennon

Name	Jane Lennon
Occupation and Family Structure	She is the morning news anchor for a national broadcasting company, where she has worked for the past 20 years. She is 56 years of age, divorced, and the sole supporter of her two children, Everett, aged 18, and Marshall, aged 14. Marshall suffers from severe medical and developmental issues.
Current and Expected Future Employment Income	She currently earns $1 million per year as a broadcaster. She plans on retiring in four years. With typical raises in her industry, she estimates that the present value of her pre-retirement income is $4.5 million.
Financial Assets and Liabilities	She has an investment portfolio worth $8 million, which consists of 30% equities and the remainder in fixed-income securities. She also owns $1 million in shares of the broadcasting company she works for, but she is restricted from selling them for two more years. Her primary residence carries no mortgage and was recently valued at $2 million. She also owns a vacation property worth $3 million, with an outstanding mortgage of $1 million. Her defined-contribution pension plan has vested and is valued at $2.5 million.
Aspirational Goals and Extended Liabilities	Everett is just beginning university and plans to pursue a medical degree. Lennon plans on paying for his entire education and living expenses as well as providing some assistance in funding his future practice. She believes that these goals will be covered with $1.5 million in present value terms. She has begun the process of setting up a special needs trust to provide lifetime benefits for Marshall that will not interfere with the government benefits that he is eligible to receive. It will be funded with $2 million within the year. She recently received an honorary doctorate from her alma mater and has started the process of endowing a chair in its communications department. She anticipates that the funding will be made available to the university in two years; it has a present value of $1.75 million. The present value of future consumption is estimated to be $9 million.
Risk Tolerance	In the past, she has had a tendency to sell winning investments to avoid the risk of giving back gains. She also has had a tendency to retain losing investments even when there is little chance of them recovering in value.

Based on the information in Exhibit 1, Lennon’s economic net worth (in $ millions) is closest to:

1. A.4.75.

2. B.5.75.

3. C.1.25.

Solution

B is correct. The economic net worth is the difference between the total assets and the total liabilities (21.00 – 15.25 = 5.75), as calculated in the following economic balance sheet.

Economic Balance Sheet of Jane Lennon (in $ millions)

Assets	Liabilities and Net Worth
Financial Assets	Financial Liabilities
Investment portfolio	8.00	Mortgage: vacation property	1.00
Restricted shares	1.00
Real estate: residence	2.00	Extended Liabilities
Real estate: vacation property	3.00	Everett’s education	1.50
Defined contribution pension plan	2.50	Trust for Marshall	2.00
		University endowment	1.75
		PV of future consumption	9.00
Extended Assets		Total Liabilities	15.25
Human capital	4.50	Net Worth
		Economic net worth	5.75
Total Assets	21.00	Total Liabilities and Net Worth	21.00

A is incorrect. It ignores the restricted shares but keeps everything else: (21 – 1) – 15.25 = 4.75

C is incorrect. It ignores earnings until retirement (human capital): (21 – 4.5) – 15.25 = 1.25

Overview of Asset Allocation Learning Outcome

1. Formulate an economic balance sheet for a client and interpret its implications for asset allocation