Reading Managing Individual Investor Portfolios FinQuiz.com FinQuiz.com CFA Level III Item-set - Solution Study Session June 2018 Copyright © 2010-2018 FinQuiz.com All rights reserved Copying, reproduction or redistribution of this material is strictly prohibited info@finquiz.com FinQuiz.com © 2018 - All rights reserved Reading Managing Individual Investor Portfolios FinQuiz.com FinQuiz Level III 2018 – Item-sets Solution Reading 8: Managing Individual Investor Portfolios Question ID: 12493 Correct Answer: B Cautious investors are generally averse to losses as a result of their current financial situation or past experiences and have a strong desire for financial security These investors prefer low-volatility investments, which have little potential for losses Thus, their portfolios exhibit low turnover and volatility Methodical Investors carefully follow market analysts or undertake research on investment strategies These investors rely on analysis and facts and thus not form emotional attachment to their investments Their discipline makes them conservative investors Individualistic investors gain information from a variety of sources and are not afraid to exhibit investment independence in taking a course of action They place a great deal of emphasis on hard work and insight Additionally such investors are not reluctant in questioning the validity of their sources Based on Mark Bowe’s statement to his financial adviser, he is categorized as a methodical investor for the following reasons: He likes to rationally think out an investment – implying he prefers researching investments before undertaking them He uses the terms ‘rational’ and ‘economic sense’ implying that he does not like to form emotional attachment to his investments He stresses on investment discipline Question ID: 12494 Correct Answer: A Spontaneous investors include those investors who like to follow the latest investment ‘hype’ and constantly adjust their portfolios to include the new investment craze The portfolios of these investors exhibit a high level of portfolio turnover and frequent position adjustments Based on Lisa Bowe’s statement, she can be categorized as a conservative investor for the following reasons: She is averse to high portfolio losses due to her parent’s risk-taking habits She has expressed her desire to minimize the couple’s portfolio volatility to keep retirement funds safe FinQuiz.com © 2018 - All rights reserved Reading Managing Individual Investor Portfolios FinQuiz.com Question ID: 12495 Correct Answer: C The after-tax nominal return required on the Bowe’s portfolio is calculated as follows: € Annual Salary* 75,000 Less: Taxes [75,000 × 35%] (26,250) Inflows 48,750 Less: Annual Living Expenses* (100,000) Net Annual Inflows/(Outflows) (51,250) Investable Assets Inheritance Mutual fund Cash savings Equity fund Less: Charitable Donation Net Investable Assets 1,500,000 80,000 65,000 50,000 (25,000) 1,670,000 *Since increases in annual living expenses are to be offset by increases in annual salary, inflation has been ignored The after-tax nominal return required to generate a portfolio value of €3 million in 26 years time is approximately 4.7% (N = 26; I/Y = ?; PV = 1,670,000; PMT = 51,250; FV = 3,000,000) Question ID: 12496 Correct Answer: C Currently the Bowes have a net annual outflow of €51,250 which means their living expenses must be partially financed out of their portfolio Thus increases in the amount of living expenses will result in an increase in the annual net outflows to be funded by the portfolio and a decrease in their ability to tolerate risk If Mark Bowe’s father dies, he will no longer be required to pay for his medical expenses, decreasing the couple’s living expenses This should increase the Bowes’ ability to tolerate risk as the available portfolio funds should increase Should the Bowes give birth to one or more child, thereby increasing their family size, their ability to tolerate risk may decrease as their required living expenses should increase This may result in a decrease in their ability to tolerate risk Should Lisa Bowe become employed, the Bowes’ annual salary base and post-retirement pension should increase A wider income base implies less dependence on the portfolio to fund their living expenses Thus ability to tolerate risk increases FinQuiz.com © 2018 - All rights reserved Reading Managing Individual Investor Portfolios FinQuiz.com Question ID: 12497 Correct Answer: B The Bowes have a long multi-stage time horizon comprising of three stages: • Present to €25,000 charitable donation (3 months) • 25,000 charitable donation to retirement/retirement charitable donation (26 years) • Retirement onwards A fourth time horizon may include the possible death of Mark Bowe’s father However since the event is uncertain it is preferable to avoid including the event as part of their time horizon The couple plans to have a child soon this may suggest the inclusion of a potential time horizon stage Question ID: 12498 Correct Answer: A Desmarais has stated that the shortfall risk should not fall below – 12.0% The shortfall risk measures (expected total return minus two standard deviations) for the four proposed allocations are as follows: Allocation A = 4.9% − [2 × (6.5%)] = − 8.1% Since – 8.1% > − 12%, Allocation A is appropriate Allocation B = 5.1% − [2 × (8.7%)] = − 12.3% Since − 12.3% < − 12.0%, allocation B is inappropriate Allocation C = 7.2% − [2 × (12.6%)] = − 18.0% Since – 18.0% < − 12.0%, allocation C is inappropriate Allocation D = 8.9% − [2 × (16.7%)] = − 24.5% Since – 24.5% < − 12.0%, allocation D is inappropriate Question ID: 5370 Correct Answer: B Inflows Annual earnings $350,000 Outflows Living expenses $500,000 Required after-tax real rate of return = $500,000 − $350,000 = 3.33% $4,500,000 Required after-tax nominal rate of return = 1.0333 x 1.05 = 8.5% FinQuiz.com © 2018 - All rights reserved Reading Managing Individual Investor Portfolios FinQuiz.com Required before-tax nominal rate of return 8.5% = = 12.14% − 0.30 Question ID: 5371 Correct Answer: A The following factors increase an investor’s ability to take risk: James and Jones have a long time-horizon James surging popularity could help him get more endorsements James and Jones not have to support anybody other than themselves Question ID: 5372 Correct Answer: A The portfolio has a single-stage long-term time horizon as none of the circumstances are expected to change in the near future 10 Question ID: 5373 Correct Answer: C The portfolio needs to provide for the expenses shortfall of $150,000 11 Question ID: 5374 Correct Answer: B Answer: B Both James and Jones are taxed at 30% which should be a significant consideration while making the portfolio 12 Question ID: 5375 Correct Answer: A Inflows Annual earnings $350,000 Outflows Living expenses $500,000 Required after-tax real rate of return $500,000 − $350,000 = = 3.33% $4,500,000 Required before-tax real rate of return = 3.33% = 4.76% − 0.3 FinQuiz.com © 2018 - All rights reserved Reading Managing Individual Investor Portfolios FinQuiz.com Required before-tax nominal rate of return = 1.0476 x 1.05 = 10.00% Taxes on withdrawals mean that inflation component will not be taxed Only the withdrawals required to fulfill the liquidity would be taxed at 30% This means part of the return goes taxfree for as long as it is kept inside the portfolio FinQuiz.com © 2018 - All rights reserved .. .Reading Managing Individual Investor Portfolios FinQuiz. com FinQuiz Level III 20 18 – Item- sets Solution Reading 8: Managing Individual Investor Portfolios Question ID: 124 93 Correct... [2 × (6.5%)] = − 8. 1% Since – 8. 1% > − 12% , Allocation A is appropriate Allocation B = 5.1% − [2 × (8. 7%)] = − 12 .3% Since − 12 .3% < − 12. 0%, allocation B is inappropriate Allocation C = 7 .2% ... = 1. 033 3 x 1.05 = 8. 5% FinQuiz. com © 20 18 - All rights reserved Reading Managing Individual Investor Portfolios FinQuiz. com Required before-tax nominal rate of return 8. 5% = = 12. 14% − 0 .30 Question