Qbank - Rebalancing

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FrankCFA

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Which of the following statements regarding the risk consequences of asset allocation strategies is least accurate?

A) Constant mix assumes relative risk tolerance is directly related to wealth.
B) With a buy and hold strategy, the investor’s tolerance for risk is zero if the value of the investor’s assets falls below the floor value.
C) Constant proportion portfolio insurance (CPPI) actively assumes risk tolerance is directly related to wealth.
 
A - Is the least accurate. This strategy increases allocation to risky assets as wealth declines
The other two choices:
B - True, the bonds act as a floor with buy and hold
C - True, allocation to risky assets increases as wealth increases
 
How about C? Doesn’t “Buy and Hold” assumes risk tolerance is directly related to wealth?
 
B. Correct me if I’m wrong but the floor value for B&H is the amount originally allocated to cash. Thus the portfolio can’t actually fall below the floor value.
 
I think the answer is (B) because Reading 31 Monitoring and Rebalancing states “The implication of using [a buy-and-hold strategy] is that the investor’s risk tolerance is positively related to wealth and stock market returns. Risk tolerance is zero if the value of stocks declines to zero” (page 96).
So it sounds like risk tolerance = 0 if value of stocks = 0, not if the value of the investor’s assets fall below the floor value (i.e., the value of risk-free assets).
FrankCFA - Could you provide the answer for this thread?
Thanks!
OMGMileyCyrus
 
“A” is the correct answer.
“B” is wrong because an asset’s allocation will become 0% below floor, implying 0 risk tolerance
“C” is wrong because in CPPI, as wealth (portfolio value) rises, percentage allocation and hence, risk tolerance, also rises, implying positive correlation with wealth.
“A” is CORRECT because constant mix assumes risk tolerance is CONSTANT regardless of wealth levels, implying that percentage allocation and risk tolerance will remain constant throughout the holding period.
 
B - once the floor is set, porfolio value can’t fall any lower than that.
What’s the answer say?
 
Kaplan Answer: A
Agree?
Kaplan Rationale:
CPPI, not constant mix, assumes risk tolerance is directly related to wealth. A constant mix strategy assumes that relative risk tolerance is constant regardless of wealth levels but that absolute risk tolerance is positively related to wealth. For the constant mix investor as wealth increases they are exposed to a greater dollar amount of equities thus absolute risk tolerance has increased but the percent invested in equities has remained the same hence their relative risk tolerance has not changed.
 
FrankCFA wrote:
Kaplan Answer: A
Agree?
Click to expand...
Constant mix assumes CONSTANT MIX. Which means you hold the constant mix of bonds and equity and cash no matter what your wealth level. So yeah, risk tolerance does not adjust at all to wealth levels. This is a really simple question…
 
Thanks, JSobes. That makes a lot of sense. Thanks for clarifying for the rest of us!
 
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