2011 Essay Question #2 Individual Portfolio Management

We covered question #1 in the 2011 Level III CFA Program essay section last week. This week we look at question #2, probably one of the two most important questions you will study in your test prep. That’s because it is one of the two types of questions you will get on the exam and is usually worth more than 10% of your morning section score. The question in 2011 was worth 23 points (12.8% of total essay points) and combined with #1 made individual portfolio mgmt more than 10% of the total level 3 exam.
Please download the 2011 Morning Section and Guidelines answers from the CFA Institute’s website and follow along with question #2.
The individual portfolio management question will always be one of two types of calculations:

  • Single-period return like 2011: Look for clues like, “first year of retirement,” or, “cash flow required one-year from now.”  As with both types, SHOW ALL STEPS OF YOUR CALCULATIONS!
    – Make sure you include all cash inflows: pension, salary
    – Minus all cash outflows: living expenses, mortgage & debt repay, gifts
    – Investable assets: (do NOT include primary residence unless otherwise instructed)
    – When the time period is in one year and nominal:  Add the rate of inflation to the real return as in guideline answer (should be geometrically but graders usually give credit for added as well). Remember “real” return is without inflation.
  • Inflation is one of the points that gets many candidates, remember to multiply current living expenses by the rate of inflation. As shown in the guideline answer, (current expenses * 1+ inflation). For the required rate of return, the Institute will almost always take either a geometrically-calculated (after-tax r times 1 plus inflation) or just adding the inflation to the required return.

– Rates of return on these questions are usually within the realm of reason (around 4-6% real, 6-10% nominal) so if you work the problem and get something like 15% or more, go over your calculations because you might have something wrong

  • The Institute usually keeps these questions and calculations fairly easy and in the same format. If yours is varying wildly, you may want to go back over the information and make sure you are not complicating it unnecessarily. Practicing several years’ worth of essay questions will give you a feel for what the Institute is asking and what they expect in an answer. Do not neglect these past essay exams!
  • We’ll cover the multi-period return question (2010 exam) in another post.

These questions will also include questions on the IPS statement.
** Though 2011 does not ask for it, many years will ask you to, “State the return objective portion of the IPS.” A lot of candidates miss easy points because they either forget this or think that the return calculation will do to satisfy it. NO! YOU MUST STATE A RETURN OBJECTIVE! Easy points, most of the objective is just copying from the vignette. Example: The Beckers’ objective is to retire at the end of one year and live off of investments after paying debts.
– Include in return objective: the investor’s age and stage of life, inflation concerns, needed % required, other relevant facts of the case
– Do the return calculation before the return objective, as this will help with numerical requirements of return objective
Part B: Remember risk tolerance has two components (ability and willingness)
Factors affecting ability: long-term versus short-term (long-term means higher ability to TOLERATE RISK), Importance of goals (high importance means lower ability), size of income needs to portfolio size (very high % means lower ability)
Factors affecting willingness: These are usually statements in vignette (past losses and fear of future loss, desire a conservative approach)
** Remember: When the ability and willingness to tolerate risk are in conflict go with less overall risk tolerance. Example: high willingness but low abilityà investors have low overall portfolio risk tolerance.
Part C: I always remembered TUTLL as my acronym for the five IPS constraints. However you choose to remember them will work. Most of the questions in the past have centered around how the constraints affect risk tolerance (ability and/or willingness) so be sure to be able to tie them back to risk and return.
Don’t forget, you need to know these for institutional investors as well. Each institutional investor has a “common” constraint profile that you should remember. We’ll cover these in another post.
Time– length of life stages is important as well as children’s ages, explicitly write how many stages and whether long-term or short-term (usually long-term)
Unique– large stock holdings or insider positions, client behavioral characteristics (socially responsible investing), any contradictions in the case
Taxes- tax-free investments, types of taxes (wealth, capital gains, income, estate)
Legal- Trusts, prudent investor rules
Liquidity- short-term living expenses, emergency cash, plans to pay off debt
Part D: Choosing a portfolio
– Choose from the portfolios that will satisfy minimum return requirements first (in this case, portfolio B has a chance of falling to 0 so is inappropriate)
– Part ii of Part D, question #2 is a good example of time management. Part D was worth 7 points (7 minutes) and was probably 3 points for #i and 2 points for each of the answers in #ii.
Do not spend half an hour on parts of a question that are worth marginal points! If you look at ii and have no idea (like I did when I took this exam in 2011), then move on and use the time on other questions. If you have extra time after answering the other questions, then revisit the harder questions. Many candidates run out of time in the morning because they spend an inordinate amount of time on the first two questions. The first two portfolio management questions are important, but not worth failing the entire exam because you got stuck.
We’ll cover more on individual portfolio management in other posts, but be sure to study the old exams on the Institute’s website, linked in a prior post outlining the FinQuiz strategy for the essay questions.
Let me know if you have any questions,
Joe Hogue, CFA

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