Reading 8

Managing Individual Investor Portfolios

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CFA Level III Item-set - Solution
Study Session 4
June 2018

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Reading 8

Managing Individual Investor Portfolios

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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.
2.
3.

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.

2. 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:
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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Reading 8

Managing Individual Investor Portfolios

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3. 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).
4. 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.

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Reading 8

Managing Individual Investor Portfolios

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5. 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.
6. 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.
7. 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%

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Reading 8

Managing Individual Investor Portfolios

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Required before-tax nominal rate of return
8.5%
=
= 12.14%
1 − 0.30
8. Question ID: 5371
Correct Answer: A

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.

9. 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%
1 − 0.3


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Reading 8

Managing Individual Investor Portfolios

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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 taxfree for as long as it is kept inside the portfolio.

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