EOC Q: Johnson is a 35 year old professor with a stable and secure annual income of $175. Johnson has comparable total wealth and exhibit moderate risk tolerance.
They ask for which allocaiton to pick. The answer is Strategy A, which is 100% stocks and AAA-rated government bonds. Next choice( the one i picked) is 80% stocks/20% bonds.
the explanation is: Given johns age of 35, the optimal allocaiton to strovks is 100%. HC will gradually decrease and FC will increase as she ages. She should gradually reduce the amount ivnested in stocks and increase the amount investedi n the RF asset over time.
wtf… then the next question. Lee is 35 year old equity trade, with $200,000 annual income. Income has a 0.9 coorrelaiton with the S&P 500.
The answer recommends a 80% allocaiton to stocks and 20% allocaiton to AAA-rated gov bonds. (page 427 - 428).
Answer: A higher correlaiton between HC and the stock market results in less diversificaiton and higher risk for the total portfolio. - obvious
An investor must invest more finanncial welath in the risk-free asset. - obvious
At 0.90 correlaiton between lees HC and stock market, opitmal alocaiton is 20% risk free asset and 80% stocks. Lees allocaiton to stocks is higher than might be expected given the correlaiton between income and S&P 500 because of behaviorial factors. He is an equity trader and likley to believe he knows stocks and have a relatively high degree of risk tolerance. Assuming weaker correlaitons between his income and the S&P 500, the alloocation to the RF asset will bel ower and alocaiton to stocks will be greater. ---- WTF?
we are taught not to assume anything, but they answered this question assuming behavioiral finance.
To me it seems a bit exagerated as well. I am not at all in asset management. I don’t know what common practice is. Although if you consider human capital it makes some sense. At 35 with such a salary you could have 20% financial capital 80% human capital over total capital. With such a job considered as equivalent to bond exposure in terms of risk, then it is as if you already had 80% of bond like exposure so you wouldnt want to add more
When the book says to use ‘experience’ then 80/20 at age 35 is usually the correct choice regardless of the correlation to the equity market.
However, when it’s purely HC/FC related, always always look at the correlation between HC and the equity market. That will determine the allocation. If there is no correlation, go with an aggressive equity allocation. If there is some, do a mix of 80/20 as a start then gradually decrease over time as they approach retirement.
Seems to me this is one of those areas I find myself rolling my eyes as I work through the questions. I guess we just have to deal with it.
Well yes the second one it definitely weird. When there are behavioral biases and especially when these are of an emotional type, you can adjust asset allocation compared to an optimal allocation according to rational asset allocation, but no more than 15% per asset class weight. Here it is just totally the opposite portfolio. Makes no sense to me either…
Most of this chapters questions as I have stated multiple times in the past - are very illogical. However they seem to use 2 charts in the reading (9 and 12 if I am not mistaken) to derive the allocations.
I agree with you Zulu. Same feeling. But it’s probably due to the nature of the content. Much more qualitative and judgemental than L2. I did not pass last year because i was very uncomfortable with the content + definitely had the wrong method of learning anyways
this chapter made perfect sense to me, and I highly appreciate the insights it offers on portofolio management. Investor who don’t take a HC/FC approach basically create a mental accounting-type portofolio that does not optimize using all their sources of wealth. If you think of your investments accounts (e.g., bank account) as separate from your salary (i.e., present value of future salary), then you basically take the more traditional approach to portofolio management. If you think of your salary as a fixed income bond (assuming that it’s uncorrelated to equity markets), then you realize that to achieve better return/risk optimization, you need to invest your FC more equity like.
I basically answered the questions the same way you did and was confused at the solution as well. I thought we must look at their age and their correlation of HC to the equity market to determine allocation. The question that had a 0.9 correlation to the equity market and a solution of allocating 80% to equity seems to contradict what the reading says. I suppose we need to take into account BF as well when answering these questions?
I got the same questions wrong. I do not know the actual CFAI explanation, but I assumed they were using an 100-age allocation to stocks or the “standard” 60-40 to calculate the appropriate allocation. In which case, even with 100% allocated to stocks in Johnson’s financial portfolio, his human capital still over allocates his entire portfolio to bonds. Seems very subjective and I doubt there would be a test question without including the information needed to calculate his PV of future earnings and his target asset allocation.