CFA CFA level 3 CFA level 3 CFA level 3 CFA level 3 CFA volume 2 finquiz item set answers, study session 4, reading 8

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

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CFA Level III Item-set - Solution

Study Session 4 June 2018

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FinQuiz Level III 2018 – Item-sets Solution

Reading 8: Managing Individual Investor Portfolios

1 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 do 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:

1 He likes to rationally think out an investment – implying he prefers researching

investments before undertaking them

2 He uses the terms ‘rational’ and ‘economic sense’ implying that he does not like to form emotional attachment to his investments

3 He stresses on investment discipline

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:

1 She is averse to high portfolio losses due to her parent’s risk-taking habits

2 She has expressed her desire to minimize the couple’s portfolio volatility to keep

retirement funds safe

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Correct Answer: C

The after-tax nominal return required on the Bowe’s portfolio is calculated as follows:

€

Investable Assets

*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)

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

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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)

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

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

Inflows

Outflows

Required after-tax real rate of return

=$500,000 − $350,000

$4,500,000 = 3.33%

Required after-tax nominal rate of return

= 1.0333 x 1.05 = 8.5%

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Required before-tax nominal rate of return

1−0.30 = 12.14%

The following factors increase an investor’s ability to take risk:

1 James and Jones have a long time-horizon

2 James surging popularity could help him get more endorsements

3 James and Jones do not have to support anybody other than themselves

The portfolio has a single-stage long-term time horizon as none of the circumstances are

expected to change in the near future

The portfolio needs to provide for the expenses shortfall of $150,000

Answer: B

Both James and Jones are taxed at 30% which should be a significant consideration while making the portfolio

Inflows

Outflows

Required after-tax real rate of return

Required before-tax real rate of return

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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

tax-free for as long as it is kept inside the portfolio

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