Investment Policy Statement/Ability to Take Risk

[abashtavy]

While the entire curriculum went relatively smoothly, the questions in Schweser to the very last chapter left me puzzled.
1. Joe Smith has investment portfolio $5m, to maintain standard of living she needs $250k per year. She’s 68, in good health, play golf. Expenses are expected to grow at an expected inflation rate of 2%.
What’s the return objective?
A. 3%
B. 5%
C, 7%
The correct answer is 7%. Why is that?
In one year expenses will be $255k, which is 5,1% of her portfolio. In 15 years it will be $336,467, which is still short of 7% from $5m.
How can we calculate that? (Surely not [yearly spending/value of portfolio+inflation]?)
2. A couple have $58,000 combined salary, have 4 children and inherited $500,000. No other investments, $60,000 credit card debt.
The answer claims their “situational profile” means they’ve got above average ability to tolerate risk without elaborating why.
And several other dubious questions/answers like that second one. What are the rules here? Is $58k per year for 6-mouth family enough to not use income from portfolio on spending (the lady from the first question would yell “NO!”) and how are we supposed to decide it? By the way, the lady from the 1st question was gauged to have average ability to take risk.

 

[krokodilizm]

I think you overly simplified cases and provided highlights only, so the conclusions do not smoothly follow from information given, such as in second example. I do agree though that IPS questions are somewhat vague and debatable.
Still, answer to 1 makes sense to me:
5m * (X-2)=250k
Find X

 

[S2000magician]

Who ever heard of a woman named “Joe”?
“Jo”? Yes. “Joe”? Never!
That’s the first clue that this question is flawed.

 

[abashtavy]

Okay
1. Jane Smith has an investment portfolio of $5m. She is 68, retired, and has no children. After her death, she wishes to leave portfolio to a local art museum that has given her relatively free access to art exhibits over the past decade. Her health is better than average, and she maintains an active lifestyle consisting of frequent swimming, biking and playing tennis with friends at her county club. Smith estimates that to maintain her standard of living, she needs $250,000 per year. Expenses are expected to grow at an inflation rate of 2%. She states that as a retiree, her tolerance for risk is “below average”. Smith has come to you for assistance in investing her assets.
krokodilizm: what does (X-2) represent?
If her spendings are 5% of portfolio and grow at 2%-rate, it doesn’t mean they become 7% of portfolio, or am I missing smth?
2. William & Elizabeth Elam recently inherited $500k. They are both 30 years old. Willian is employed as a factory worker with salary of $40k, Elizabeth is a teacher’s aide and has a salary of $18k. Their four children are aged 6, 5, 4, and 3. They have no other investments and have a current credit card debt of $60k. When interviewed, William made the following statements:
- I love being on top of the latest trends in investing
- My friend Keith told me that really smart investor holds stocks for no mre than a month. After that, if you haven’t made profit, you probably won’t
- Technology stocks are hot! Everyone has been buying them
- Can you believe that my mother still has the same porfolio she had a year ago? How boring!
Elams’ ability & willingness to take risk are most appropriately characterized as:
A. above average willingness and ability
B. below average willingness and ability
C. average ability and above average willingness
The correct answer is A

 

[krokodilizm]

It is easy to justify any answer once you know it is correct. I am sure Kaplan did too so not sure there is any merit elaborating. Still, a couple of rules of thumb.
The kids have a long way to college, so they arent expensive yet. The interview highlights willingness to take risk. Also, given the large inheritance relative to family debt you can be sure Will will burn the money. Easy come easy go.
Regarding first question, 2% is like a hurdle rate which the manager must overcome to produce a return of 250k per year. I think the word expense is putting you off, whereas the key is inflation. Given inflation 2% a nominal return of 7% ensures a real return of 5%.