Q: “Smith is the financial advisor to Steve Hernandez and Michael Lee. Hernandez is a 35-year old physician with an annual income of $200,000 and financial wealth of $250,000. Hernandez’s financial wealth is expected to significantly increase to $1,000,000 over the next 2 months due to an inheritance. Michael Lee is a 35-year old equity trader with an average annual income of $200,000. Lee’s income exhibits a 0.90 correlation to the performance of the S&P 500.”
“Recommend which of the following portfolio construction strategies are optimal for Hernandez and Lee and justify the selections.
Stocks AAA-rated government bonds
Can someone please explain why Strategy C is optimal for Hernandez and Strategy B is optimal for Lee.
Is this question asking the overall portfolio or the FC portion that balances HC?
I am pretty they are trying to ask FC portion that balances HC, the rule of thumbs
As individuals financial wealth increase, the portfolio should be allocated more and more towards lower risk investments.- Possibly the reason why C for Harndez and not going to extreme 0 100 because he has age on his side
With Strategy B Lee’s we minimize correlation between HC and FC thus reducing their earnings risk
Hope it helps!
The answer for Lee is definitely an odd one as I would expect D (20% 80%) since his HC is highly correlated with the market (equity-like HC), his FC should be more towards less risky assets (e.g. fixed income or risk free bonds).
Though, there’s no mentioned of his amount of FC in relation to his total wealth.
I’ve also checked CFAI for any errata but nothing in Reading 14 (http://www.cfainstitute.org/Eratta/2014_level_III_errata.pdf) but I’ll try to email CFAI and see what they have to say regarding this.
As for Hernandez, his FC is now significantly more than his HC, hence he is able to allocate more towards a riskier asset, since the normal allocation is 60/40 (equity/bonds), he’s allocating 5% more towards equity.
My question here is why can’t he do 80/20 since his FC is significantly more now, he’s relatively young and his income is certain?
Also, CFA doesn’t define what age is considered as young which make things trickier. For example, is 35 considered young? Assuming you start working at 22 and retire at 65 which means your working timespan is 43 years. Hence, 22 years + (43/2) = 43.5 would 35 is not even his half way potential and should be considered young?
@Alta12 I just read the question and answer, and I believe they made a mistake. I find Strategy C for Hernandez to be at least believable but not Strategy B for Lee. He has a similar annual income to Hernandez but less financial wealth and his income is more correlated to equity markets. This means his portfolio should be less invested in stocks and more in bonds compared to Hernandez. I’d say C/D for Hernandez/Lee or otherwise B/C would make sense, but not C/B.
I pasted the official answer to the question below for convenience.
“Strategy B is optimal for Lee. The optimal allocation of financial wealth becomes more weighted towards risk-free assets, than would otherwise be indicated based on age, as income and stock market returns become increasingly correlated. A higher correlation between human capital and the stock market results in less diversification and higher risk for the total portfolio. To reduce this risk, an investor must invest more financial wealth in the risk-free asset. At a 0.90 correlation between Lee’s human capital and the stock market, the optimal allocation is 20% to the risk free asset and 80% to stocks. Assuming weaker correlations between his income and the S&P 500, the allocation to the risk free asset will be lower and allocation to stocks will be greater.”
“Thank you for your query; the text is correct as written. Lee’s income exhibits a correlation of 0.90 to the performance of the S&P 500. The allocation is affected by the correlation of income to risky assets; he is less heavily invested in stocks than someone of this age with similar but steadier income. However, behavioral factors (Lee is an equity trader and will feel he knows stocks; also, an equity trader is likely to have a relatively high degree of risk tolerance) and his relatively high income result in a heavier weighting in stocks than might be expected given the correlation of income to risky assets. I hope this helps.”
@sophie @Alta12 i still don’t quite agree with CFAI. Just because he’s an equity trader he felt he knows stocks better (overconfidence bias) doesn’t mean he could should take on excessive risk, shouldn’t an advisor educate him to diversify his portfolio?
Since there’s no FC mentioned we’ll assume he has the same amount as Hernandez ($250k), along with his (not-too-certain <- risky) salary of $200k which is highly correlated (<- risky) with the market, that means he's pretty much having 200k (HC) + 200k (80% allocation to stocks in FC) out of $450k in stocks which comes to the total of 89%. That doesn't look too diversify to me? Should I just accept this or or ask for more clarification?
@vincentt I don’t agree with their answer at all. Did they read the answer and reasoning at all? It still doesn’t make sense particularly:
“At a 0.90 correlation between Lee’s human capital and the stock market, the optimal allocation is 20% to the risk free asset and 80% to stocks. Assuming weaker correlations between his income and the S&P 500, the allocation to the risk free asset will be lower and allocation to stocks will be greater.”
With such high correlation between Lee’s HC and the S&P 500 i.e 0.90 he should really be diversifying his FC by investing more in risk free assets. And as he ages and his HC reduces, his FC allocation to risky assets needs to increase. That’s how I see it.
The official answer stumped almost everyone here in the forum who replied. Surely, we can’t all be going MAD? @sophie Are we all over thinking it?
@vincentt @Sophie @Betankrich @MM12 I just received an explanation from Schweser instructor. Lee’s strategy B is based on figure 11 on p.401 (which shows the asset mix for a correlation of 0.90 to S&P 500) and Hernandez is based on figure 10 p.400. It makes sense now. But the question didn’t say refer to figures 10 and 11. WT!
Thanks for that @Alta12, however don’t you think it is still rather inconsistent with the overall statements.
In CFAI Level 3 Volume 2 page 399, “For young investors with equity like human capital, the financial assets should be invested predominantly in fixed income assets. Because the value of one’s human capital declines with age, the share of risk-free assets in the stockbroker’s portfolio will also decline and the share of risky assets in the portfolio of financial assets will rise until retirement.”
In this case, Michael Lee has a human capital that’s highly correlated with the market which is definitely equity like hence based on the CFA text (quoted above) he should invest predominantly in fixed income to balance up the risk in his human capital shouldn’t he?
And looking at Case 4 (Vol 2 page 401), investor’s age 45, moderate risk and FC of $500k, “As Figure 11 shows, the optimal allocation becomes more conservative (i.e. more assets are allocated to the risk-free asset), with increasing correlation between income and stock market returns. One way to look at this outcome is that a higher correlation between human capital and the stock market results in less diversification and thus higher risk for the total portfolio (HC + FC).”
(Statement 2 just reconfirmed Statement 1). when you have risky or equity-like HC, you should balance it up with a less risky or risk-free FC.
However, the questions are:
How much FC does Michael Lee have?
If we assume Lee’s context is based on Case 4 (Figure 11 p401) with an FC of $500k and the annual salary of $200k (EOC Q3), he would have a total of less than 86% allocated to risky asset; ( based on 80/20 in the $500k FC and $200k equity-like HC) -> (400k + 200k) / 700k.
86% of his total wealth (HC + FC) into risky asset for someone with a risk aversion of 4 (moderate) is extremely high. If you refer back to the chart in Figure 10 (with the same risk aversion) a total wealth of $750k the allocation to risk-free should be slightly above 30% which means the closest suitable strategy for Lee should be C.
However, the question did not specify the FC for Lee which could also mean the FC is at its minimal, and based on Statement 3, to achieve the 60/40 target asset allocation for moderate investor like Lee, we would have to invest 100% into risk free. Since HC is illiquid and we can’t do much bout that until we have more FC to balance up the total wealth risk.
From the Solution in CFAI for EOC Reading 14 Q3 (Vol 2 p429) referring to Lee’s Strategy B , “Assuming weaker correlations between his income and the S&P 500, the allocation to the risk free asset will be lower and allocation to stocks will be greater.”
This would confirms my points above and contradicts Strategy B.
Case 3 (Vol 2 page 400) an investor with moderate risk preference and with a low correlation HC, “An increase in initial financial wealth not only increases total wealth but also reduces the percentage of total wealth represented by human capital. In this case, human capital is less risky than the risky asset. When initial wealth is low, human capital dominates total wealth and asset allocation. As a result, to achieve the target asset allocation of a moderate investor – say, an allocation of 60% to risk-free asset and 40% to risky asset – the closest allocation is to invest 100% of financial wealth in the risky asset because human capital is illiquid. As initial wealth rises, the asset allocation gradually approaches the target asset allocation that a moderately risk-averse investor desires.”
What do you guys think? I’m still waiting for a further response from CFAI and see how it goes, otherwise I’ll just move on and assume that this is a very badly written question. #-o
@vincentt I agree with you on the inconsistency! Let’s see if CFAI will provide further clarification. How is your study going by the way? @sophie Is it normal to be hitting just 50% of the EOC questions after reading a chapter the entire day? So demoralising! I have taken the last month off from work to study. Any other tips Sophie? Thanks! 🙂
@Alta12 unfortunately (for me at least) it is the same 50%. But fret not, the only way is up and continuously improve! That’s what I tell myself certainly as Level 3 is quite different in the sense that you ‘think’ you know the syllabus (as it’s “lighter” than L2 materials), but somehow curveballs do come out anyway. Will be here to discuss more questions like this one – I love the debate so far and I’m on your side being equally confused with the answer CFA provided.
Just not let questions like these demoralise you. Sometimes it’s one of those things where you say ‘OK maybe it’s a badly written question given agreement with a few other candidates’ and move on. Once you hit the practice papers you’ll quickly see where the gaps are, even for Level 3. I find time management key for L3, often when doubt creeps in during exam for L3, the time management somehow goes out of the window – so I think it’s better to write something, and come back to the question if you need more thinking time, but never go out of the allocated time per question.
Having the whole last month off? Nice! You’ll have loads of time then to practice, revise and reiterate. I’ll be looking out for practice papers for the community by mid/end April, so will update you guys on that as L3 papers are notoriously hard to find (good ones at least)
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