Reading 13 Practice 2&3 Human Capital vs Financial Capital

[oleanderleigh]

Have difficulty understanding the answers to the following questions. Johnson and Hernandez are of similar situation, stable and secure income. Why Johnson can choose Strategy A, while Henandez can only choose Strategy B? Same question with Wu and Michael.

1. Smith is utilizing the following capital market return assumptions in his recommendations to his clients:
2. Asset
   Compounded Annual Return
   Standard Deviation (Risk)
   AAA-rated government bonds
   5%
   —
   Stocks
   9%
   20%
   
   Smith is the financial advisor to Nancy Johnson and Michael Wu. Johnson is a 35-year old professor with a stable and secure annual income of $175,000. Wu is a 35-year old stockbroker with an income that averages $175,000 per annum and is highly correlated to risky asset returns. Johnson and Wu have comparable total wealth and exhibit moderate risk tolerance.
   Recommend which of the following portfolio construction strategies are optimal for Johnson and Wu and justify the selections.
   Allocation
   Strategy A
   Strategy B
   Strategy C
   Strategy D
   Strategy E
   Stocks
   100%
   80%
   65%
   20%
   0%
   AAA-rated government bonds
   0%
   20%
   35%
   80%
   100%
   
3. 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.
   Allocation
   Strategy A
   Strategy B
   Strategy C
   Strategy D
   Strategy E
   Stocks
   100%
   80%
   65%
   20%
   0%
   AAA-rated government bonds
   0%
   20%
   35%
   80%
   100%
   

 

[JSobes]

The moderate risk tolerance would be the hint for question 2, yet given his stable income he should have a higher ability to take on risk. This would bring you to consider A and B on ability, and skew to B on risk tolreance?
In question 3 there’s no mentioning of any hampering of risk tolerance, but honestly I don’t know if answering strategy A is ever really that acceptable for someone in their mid-30s.