Peter and Cornelia Hargrave, both age 60, have a $2.5 million investment portfolio. The Hargraves want to retire in five years and as a result, use a strategic asset allocation of 55% equities, 40% bonds and 5% cash. The portfolio is expected to provide income for 20 years after retirement, and is invested among two equity portfolio managers and a fixed income manager. Last week, the Hargraves learned that one of the equity portfolio managers has taken on extremely risky derivatives positions generating substantial losses that wiped out $500,000 of the $2.5 million portfolio. Given the change in portfolio value, the Hargraves should reduce the exposure under the strategic asset allocation to which asset class?
A)Cash.
B)Equities.
C)Bonds.
Explanation
Given the significant reduction in the portfolio value (20%) and only a modest amount of time prior to retirement, the Hargraves should reduce exposure (in terms of the percentage of the remaining portfolio assets) to riskier assets such as equities and increase exposure to less risky assets such as fixed income. The fixed income assets should be duration matched to meet the time to retirement, income needs at retirement, and life expectancy.
(Study Session 5, Module 14.2, LOS 14.c)
This just doesn’t quite make sense to me. Without further information, how can we really determine that they have the ability to reduce expected returns by reducing equity exposure and increasing fixed income exposure? In my mind, the ~20% loss in value should mean that they need to increase equity exposure (or at a minimum keep it constant) to meet their objectives. However, without knowing objectives, expected returns, risk tolerance, etc., how can we decipher from this question that they should reduce equities and increase fixed income?
Thanks for any help!