IPS Risk Tolerance -- Ability to take risk

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JamesHouston

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I always miss this one. Are there any golden rules to determine whether the investor is below /about / above average to take risk?
I know the risk-tolerance is:
–positively related to the time horizon
–positively related to the size of the portfolio
–negatively related to the return requirement
–positively related to the availability of options to cover the shortfall in case (like other income source)
Are there certain steps to determine the ability based on quantitative data? e.g. A certain return requirement would indicate above average tolerance? How about the size of portfolio that are able to take above avg. risk? Can someone help to explain or share your experience?
 
I asked a similar question before. See:
http://www.analystforum.com/phorums/read.php?13,1132153,1132153#msg-1132153
Yes. I agree that ability to take risk is..
–positively related to the time horizon
–positively related to the size of the portfolio
–positively related to the availability of options to cover the shortfall in case
But I am not sure about if it is negatively related to return requirement. I found a case in which return requirement and portfolio size are both higher but ability to take risk is lower. see: CFAI Textbook Vol 6. Practice problem for Reading 45. Q3.
I raise the same question before, my reply is that risk tolerance determines required return but not required return determine risk tolerance.
To determine the ability based on quantitative data. See below for the rule of thumb.
http://www.analystforum.com/phorums/read.php?13,1132153,1132153#msg-1132153
 
sorry, typo. I found a case in which return requirement and portfolio size are both higher but ability to take risk is “higher”. see: CFAI Textbook Vol 6. Practice problem for Reading 45. Q3.
 
Also would point to question #1 on 2008 exam (SPOILER ALERT):
Required return is 9.75%, and their ongoing net cash outflow is > 5% of their investable assets (at least until they get the remaining trust distribution). Yet their tolerance is “above average”.
Guideline answer weighs their time horizon, human capital, upcoming trust payout and large inheritance, and income stability (although, in my mind, it’s the inheritance and trust - otherwise is clearly “average”).
I agree generally with the thread above (1-2% nominal pre-tax cash need is OK, > 5% is not), but there are exceptions.
I don’t think the Institute would accept “high required return” as a justification for risk tolerance - something about the argument seems circular, if I understand correctly. Also I don’t recall seeing in any guideline answers (might be wrong here).
 
If you have Schweser 2009 Vol. 1, for the 1st exam AM answers, they have given a pretty good explaination for what you are looking for.
Cheers
 
Truly appreciate all the suggestions, they really help after looking all the examples. I haven’t had a chance to look at the CFA text Vol. 6. I will look at it tonite.
Previously I weighted heavily on the required return as one of the major determinants, and through all the examples I was able to see the other factors actually play a much bigger role in the risk tolerance—–
time horizon, size of the portfolio, HC, flexibility of changing of plans (returning to workforce/ decrease the bequest desire), availability of options to cover the shortfall in case (like other income source)
 
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