Reading 14 Lifetime Advice - Allocation to Risky assets when correlated w HC

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mightyjoe028

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Haing trouble with allocation to risky assets when HC is correlated with equities. For the practice problems (pg 368) here’s what I find
#2 allocate 65% to equities for W because of high correlation
#3 allocate 80% to equities for Lee even though nearly identical description as Wu - WHY not 65%?
#6 Answer A - allocate to fixed-income. Even if he works as a stockbroker, he is 23 years old. Should he really be more heavily invested in t-bonds? The text says he needs to balance against human capital risk, but really?
*General thoughts*
I just wanted to take the opportunity to share my general thoughts on L3. For me, this will be much harder. Lots of fluffy stuff here and not as much number crunching. The practice problems take longer having to give general responses. I am about 40 hours in having covered study sessions 3 & 4 (skipped ethics). Feeling like I am on pace as I started L2 about this time last year. Put in 350 hours for L2 and planning on more for L3. Anyone else in a similar boat?
Thanks for your responses to the questions.
 
The other general comment I forgot to make was study session 4 is one of the longest study sessions I have gone through ever. On par with the pension study session in L2 (in length not difficulty).
 
Here are my notes: Young individual with equity-like human capital (volatile with near to 1 correlation with equity returns) which dominates total wealth: 65/35. If the correlation of human capital to stocks is lower or if initial wealth is high so that human capital doesn’t dominate, the equity allocation will be higher: 80/20.
I hope this helps, i was stuck at the same point
 
Bump, I am not clear on this and the explanation from Penny Wenny doesn’t clarify it for me.
Is there a difference between the correlation between Human Capital and Risky Assets and the correlation between Human Capital and S&P 500 or Other Stock Market Index ?
I believe the problem specifies that Wu is a stock brokers and Hernandez(?) is a stock analyst. I believe they both were the same age at 35.
What am I missing? Thanks.
 
I’d buy Willa Cather a beer wrote:
Bump, I am not clear on this and the explanation from Penny Wenny doesn’t clarify it for me.
Is there a difference between the correlation between Human Capital and Risky Assets and the correlation between Human Capital and S&P 500 or Other Stock Market Index ?
I believe the problem specifies that Wu is a stock brokers and Hernandez(?) is a stock analyst. I believe they both were the same age at 35.
What am I missing? Thanks.
Click to expand...
Not really, and on the exam it will be obvious. Risky financial capital in this context is defined as equity-like. Less risky will be fixed income / bonds.
If your HC has equity-like characteristics, i.e. is volatile (bonuses, variable pay, less job security) you want to balance that risk by investing in FC that is less correlated…i.e. is more bond like.
If your HC has bond-like characteristics (i.e. you are a teacher, stable salary, job security, maybe a pension) then you want to take more risk and invest in equity-like FC.
From there, if the question is asking which portfolio / asset allocation is more suitable (i.e. give 2 reasons why, or justify in a constructed response morning question) you’re prepared
 
What Willa’s friend is trying to pin down, I believe, is why Wu should allocate his financial capital 35%-65% whereas the appropriate allocation for Lee is said to be 20%-80%.
A question, I should hasten to add, which has troubled (unnecessarily) quite a few in this forum already.
Wu and Lee are both 35-year-old, ther salaries are comparable, both their HCs are highly correlated to risky assets. So, how do we justify the different allocations to riskless and risky asset?
The CFAI text comes to the rescue in the form of a neat sentence in the Solution to question 3 (page 428 - Level III - Volume 2 - 2015 edition):
“Lee’s allocation of 80% to stocks is higher than might be expected given the correlation between his income and the S&P 500 because of behavioral factors. He is an equity trader and is likely to believe he knows stocks and to have a relatively high degree of risk tolerance”.
I.e. the apparent inconsistency between Wu’s and Lee’s allocations is explained by the author’s arbitrary assumption that Lee is a little bit of a devil-may-care on account of being an equity trader (is there anything more adventurous?) whereas, Wu, being broker, is assumed to have a lower willingness to take risk.
 
Yup those end of chapter questions particularly EOC 2 and 3 and how similar they are. Everyone struggles with that.
Your going to need your book to refer to so grab your CFAI texts: 2015 Reading 13 or 2016 Reading 12
In EOC #2 the only difference between Johnson and Wu is the correlation between HC and FC. Go to figure figure 11 and refer to the correlations on the horizontal axis.
In EOC #3 - Hernandez is 35 yrs old, doctor with bond like income, $200k income and $250k initial wealth with $1.0mm inheritance - with higher initial wealth (figure 10) the allocation to the risk free rate INCREASES, so at $1.0 mm initial wealth the % allocated to Rf is 40%. Each investor has a “terminal wealth value” they need to retire, as you get closer to that amount you dampen down the risk thus increase your allocation to Rf, play it safe per se.
Lee is same age 35, equity trader (equity like income), $200k income (all the same) but ZERO initial wealth (refer to figure 10).
Now go to the summary paragraph right before/above Case #4 (page 400 in 2016) and they make a great summary.
EOC 2 and 3 are completely separate from one another.
That help?
 
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