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Schweser QBank 2017portfolio management and wealth planning 08 asset allocation and rela portfolio management (1)

Asset Allocation and Related Decisions in Portfolio Management (1)
Test ID: 7427743

Question #1 of 83

Question ID: 465443

Tactical asset allocation is a deviation from the strategic asset allocation for the purpose of:
ᅞ A) aligning with investor's risk preferences.
ᅞ B) exceeding investor's return objectives.
ᅚ C) taking advantage of short-term capital market expectations.
Explanation
Tactical asset allocation deviates from Strategic asset allocation to take advantage of short-term capital market expectations.

Question #2 of 83

Question ID: 465454

Dynamic asset allocation is considered an advantage over static asset allocation because of all of the following factors except
it:
ᅞ A) expresses unanticipated changes in macroeconomic factors.

ᅚ B) is more cost efficient when implementing.
ᅞ C) allows for changes over time.
Explanation
Dynamic asset allocation is costly and difficult to implement. However, many investors feel that these costs are acceptable in
order to reap the benefits of dynamic asset allocation. These benefits include the allowance for changes in parameters over
time and the expression of unanticipated changes in macroeconomic factors.

Question #3 of 83

Question ID: 465512

Reid Williams is responsible for training new analysts and portfolio managers for Grames Investment Advisors. Since Grames
specializes in institutional clients, Williams wants to make sure that his new trainees know the needs of various institutional
investors. Reid gives an assignment to all of his trainees to identify general differences in asset allocations for different types
of institutional investors. One of Williams' trainees, Phil Nagy, turns in his assignment with the following statements.
Statement 1: A bank is likely to hold more bonds than an insurance company's surplus portfolio.
Statement 2:

Statement 3:

Statement 4:

An endowment is likely to hold more equities than the portfolio that funds an insurance company's fixed
annuities.
An endowment is more likely to hold more emerging market equities than an insurance company's surplus
portfolio.
A private foundation is likely to have higher cash needs than a pension fund with a low ratio of retired to active
lives.

When grading the papers, Williams gives his trainees 25 points for each correct statement. Given the grading criteria, Nagy's


grade on the paper is most likely:

ᅞ A) 100%.
ᅚ B) 75%.
ᅞ C) 50%.
Explanation
Three of Nagy's four statements were correct, for a score of 75%. Statement 1 is correct - a bank's portfolio is concerned with
funding liabilities, and therefore requires more fixed income instruments, while an insurance company's surplus portfolio is


focused on growth. Statement 2 is also correct - the portfolio that funds an insurance company's fixed annuities is likely to rely
more on fixed income securities, while the endowment has more of a total return focus. Statement 3 is incorrect - an insurance
company's surplus portfolio is very aggressive and should therefore have more emerging market equities than an endowment
that likely spends a portion of its portfolio each year. Statement 4 is correct - the private foundation has an annual spending
requirement and therefore is likely to have higher liquidity needs than a pension fund with a small number of retired employees
relative to working employees.

Question #4 of 83

Question ID: 465447

Professor Erik Rickel, an instructor for Babcock College asked his Investments 340 class to identify reasons that support the
conclusion that strategic asset allocation is the most important factor for defining portfolio performance. Three of Rickel's
students raised their hands and gave answers to his question. The answers given are as follows:
Prickett: "Defining an investor's strategic asset allocation helps the portfolio
manager focus on the investor's goals with respect to risk and return."

Rorrer:

"Results of academic studies show that the overall returns to market
timing and security selecting are minimal at best and in many cases do
not cover a portfolio's operating expenses and trading costs."

Cloe:

"Since the assets within asset classes tend to have a similar response to
macroeconomic changes, the target weights of the portfolio's chosen
asset classes will tend to drive the variability of portfolio returns."

Which of the students' statements accurately support the conclusion that strategic asset allocation is the most important factor
for defining portfolio performance?

ᅞ A) Prickett's and Cloe's only.
ᅚ B) Prickett's, Rorrer's, and Cloe's.
ᅞ C) Rorrer's and Cloe's only.
Explanation
All three of the students' statements are accurate and all three support the conclusion that strategic asset allocation is the
most important factor for defining portfolio performance. A clearly defined asset allocation provides discipline and focus on an
investor's goals by ensuring that the investor's portfolio accurately reflects the investor's desires with respect to risk and return.
Also, empirical studies support the conclusion that strategic asset allocation (not timing or security selection) defines the vast
majority of a portfolio's long term performance, and the variability of portfolio returns.


Question #5 of 83

Question ID: 465431

Strategic asset allocation is based upon:
ᅚ A) long-term capital market expectations and the investment policy statement.
ᅞ B) short-term capital market expectations and the investment policy statement.
ᅞ C) long-term capital market expectations and risk/return preferences of the investor.
Explanation
Strategic asset allocation is based on long-term capital market expectations (which forms the basis for the generation of the
efficient frontier) and the investment policy statement (IPS) of the investor. The IPS includes not only the risk/return objectives
of the investor but also the investor's constraints.

Question #6 of 83

Question ID: 465468

Which of the following statements regarding the characteristics of asset classes is most correct? Asset classes should:
ᅚ A) not be highly correlated.
ᅞ B) have an index.
ᅞ C) be negatively correlated.
Explanation
Asset classes should not be highly correlated with each other is a desired characteristic. Furthermore, asset classes should be
mutually exclusive and collectively mutually exhaustive.

Question #7 of 83

Question ID: 465514

Melissa Brown, an analyst with Mollette Capital Advisors, is reviewing the client profile of Karrie Jones. Mollette manages all of
Jones' investment assets; however, since Brown is new to the firm, she has never met Jones. She does know, however, that
Jones' asset allocation is appropriate given her age and investment policy statement. The allocation of Jones' portfolio is
shown below:
Asset Class
Cash
Intermediate-term Treasury
bonds

Allocation (%)
5%
0%

High quality corporate bonds

5%

U.S. equities

60%

International equities

30%

Given Jones' asset allocation, which of the following conclusions about Jones is most accurate?


ᅚ A) Jones' human capital makes up the bulk of her portfolio.
ᅞ B) Jones has a large amount of financial capital.
ᅞ C) Jones has a low risk tolerance.
Explanation
With only 10% in fixed assets and the rest in equities, Jones has a very aggressive portfolio. At a young age, an aggressive
portfolio like this makes sense as the individual will have a high allocation to human capital (future stream of income from
working). At this stage, the allocation to human capital will be much larger than the allocation to financial capital (investment
portfolio), therefore, the investment portfolio should be invested in riskier, high return assets. Note that Jones likely has a high
risk tolerance given the aggressive portfolio.

Question #8 of 83

Question ID: 465493

Any mean-variance efficient portfolio has the:
ᅞ A) highest return among all other portfolios.
ᅚ B) lowest standard deviation for a given level of expected return.
ᅞ C) lowest standard deviation and the highest expected return.
Explanation
A mean-variance efficient portfolio has the lowest standard deviation for a given level of expected return. Note that the lowest
standard deviation portfolio and the highest return portfolio are just two of the infinite number of efficient portfolios.

Question #9 of 83

Question ID: 465458

Dan Laske is evaluating three portfolios for investment of his retirement funds. Laske has a risk aversion value of 5. Which
portfolio would be best for him?
Portfolio

Return

Std. Dev.

A

15.0%

17.0%

B

10.6%

10.0%

C

8.8%

8.0%

ᅚ A) B.
ᅞ B) A.
ᅞ C) C.
Explanation
RZ =5
UA = E(RA) - 0.5(RZ)(σ2A) = 0.15 - 0.5(5)(0.17)2 = 0.078


UB = E(RC) - 0.5(RZ)( σ2C) = 0.106 - 0.5(5)(0.10)2 = 0.081
UC = E(RD) - 0.5(RZ)( σ2D) = 0.088 - 0.5(5)(0.08)2 = 0.072.
Portfolio B has the highest utility.

Question #10 of 83

Question ID: 465495

Constrained optimization usually involves an additional constraint that:
ᅞ A) the weights of all asset classes add up to 1.
ᅞ B) each asset class weight should be positive.
ᅚ C) short sales are not allowed.
Explanation
The weight of all asset classes adding up to one is part of un-constrained optimization. Constrained optimization has an
additional constraint that the weights of all the asset classes should be non-negative or that there be no short sales. The
weight of asset classes can be zero or positive.

Question #11 of 83

Question ID: 465500

Based on the following information, which asset class is the most significant in an efficient portfolio with an expected return of
12.50%?

The following are the long-term capital market expectations:

Asset Class

Expected
Return

Correlations
Exp. Std. Dev.
1

2

3

4

5

1

US Equity

12.00%

16.00%

1.00

2

US Bonds

8.25%

6.50%

0.32 1.00

3

Intl Equities

14.00%

18.00%

0.46 0.22 1.00

4

Intl Bonds

9.25%

12.25%

0.23 0.56 0.32 1.00

5

Alt Inv

11.50%

21.00%

0.25 0.11 0.08 0.06 1.00

The details of each corner portfolio are given below. The risk free rate is assumed to be equal to the T-bill rate of 2.5%. Using
margin is not allowed.
Asset Class Weights

Corner Expected Exp. Std. Sharpe
Portfolio Return

Dev.

Ratio

1

2

3

4

5

1

14.00%

18.00%

0.639

0.00% 0.00% 100.00% 0.00% 0.00%

2

13.66%

16.03%

0.696

0.00% 0.00% 86.36% 0.00% 14.00%

3

13.02%

13.58%

0.775 21.69% 0.00% 56.56% 0.00% 21.76%

4

12.79%

13.00%

0.792 21.48% 0.00% 52.01% 5.24% 21.27%

5

10.54%

8.14%

0.988

9.40% 51.30% 26.55% 0.00% 12.76%


6

8.70%

6.32%

0.981

0.00% 89.65% 4.67% 0.00% 5.68%

ᅞ A) International equity with a weight of 45.51%.
ᅚ B) International equity with a weight of 48.70%.
ᅞ C) Alternative investments with a weight of 20.17%.
Explanation
The expected return of 12.50% lies between corner portfolios 4 and 5 with expected returns of 12.79% and 10.54%. We solve
for w in the following equation:

12.50 = w(12.79) + (1-w)(10.54)
w = 0.87

In other words, the efficient portfolio with an expected return of 12.50% has 87% weight of corner portfolio 4 and 13% weight
of corner portfolio 5. With respect to asset classes, the weights are then derived as follows:

US equity = (0.87)(21.48) + (0.13)(9.40) = 19.91%
US bonds = (0.87)(0) + (0.13)(51.30) = 6.67%
Intl equity = (0.87)(52.01) + (0.13)(26.55) = 48.70%
Intl bonds = (0.87)(5.24) + (0.13)(0) = 4.56%
Alt. invest = (0.87)(21.27) + (0.13)(12.76) = 20.17%

Hence, International equity is the most significant asset class with the highest weight of 48.70%.

Question #12 of 83

Question ID: 465487

Darlene Szuch is constructing an asset allocation for a client and just completed the step of formulating her expectations for
the capital markets and making projections for the risk and return of various asset classes. Which of the following is her next
step in the asset allocation process?
ᅞ A) Determine the client's risk objective and return requirement.
ᅚ B) Determine the mix of asset classes that best meets the objectives defined in the
Investment Policy Statement.
ᅞ C) Monitor the various asset classes and make adjustments to market and asset class
expectations as necessary.
Explanation
The asset allocation process starts with determining the investor's risk tolerance and return objectives. Step 2 is to formulate
capital market expectations and the potential effects on various asset classes. Step 3 is to determine the mix of assets that
best meet the objectives defined in the IPS. Once the strategic asset allocation has been implemented it should be monitored
regularly and adjustments should be made to the strategic allocation as needed. Also, if identified market changes are shortterm only, the manager should determine if implementing tactical asset allocation measures is appropriate.


Question #13 of 83

Question ID: 465472

Which of the following characteristics of asset classes is most desirable? Asset classes should:
ᅞ A) have an index.
ᅞ B) be negatively correlated.
ᅚ C) be mutually exhaustive.
Explanation
One of the desired characteristics of asset classes is that they should be mutually exhaustive- or cover most of the investable
assets. They also should not be highly (positively or negatively) correlated with each other.

Question #14 of 83

Question ID: 465492

The following information is available regarding corner portfolios from an efficient frontier
Asset Class Weights

Corner

Expected

Exp. Std.

Sharpe

Portfolio

Return

Dev.

Ratio

1

2

3

4

5

1

14.00%

18.00%

0.639

0.00%

0.00%

100.00%

0.00%

0.00%

2

13.66%

16.03%

0.696

0.00%

0.00%

86.36%

0%

14.00%

3

13.02%

13.58%

0.775

21.69%

0.00%

56.56%

0.00%

21.76%

4

12.79%

13.00%

0.792

21.48%

0.00%

52.01%

5.24%

21.27%

5

10.54%

8.14%

0.988

9.40%

51.30%

26.55%

0.00%

12.76%

6

8.70%

6.32%

0.981

0.00%

89.65%

4.67%

0.00%

5.68%

The following portfolios are under consideration by an investor:

Portfolio Expected Return
A

11.0%

B

13.5%

For an investor with a risk-aversion of 6, which portfolio would have the highest utility?

ᅞ A) Portfolio B with a utility of 0.115.
ᅞ B) Portfolio A with a utility of 0.092.
ᅚ C) Portfolio A with a utility of 0.085.
Explanation
For portfolios A and B we first need the approximate standard deviation.
Portfolio A with an expected return of 11% lies between corner portfolios 4 and 5. Let w denote the weight of corner portfolio 5,
we solve for w in the following equation:

11 = (10.54)(w) + (12.79)(1-w)
w = 0.80


Approximate standard deviation of portfolio A = (0.80)(8.14)+(0.20)(13) = 9.11.

Similarly, Portfolio B with an expected return of 13.50% lies between corner portfolios 2 and 3. Let w denote the weight of
corner portfolio 2, we solve for w in the following equation:

13.50 = (13.66)(w) + (13.02)(1-w)
w = 0.75
Approximate standard deviation of portfolio B = (0.75)(16.03)+(0.25)(13.58) = 15.418.

RZ =6
UA = E(RA) - 0.5(RZ)(σ2A) = 0.11 - 0.5(6)(0.0911)2 = 0.085
UB = E(RB) - 0.5(RZ)(σ2B) = 0.135 - 0.5(6)(0.154)2 = 0.064

Question #15 of 83

Question ID: 465435

What does Strategic Asset Allocation allow managers to do with respect to systematic risk?
ᅞ A) Reduce.
ᅚ B) Monitor and control.
ᅞ C) Identify and minimize.
Explanation
Strategic asset allocation reflects the investor's desired systematic risk exposure and allows the manager to monitor and
control risk - not to reduce or minimize it.

Questions #16-21 of 83
Sam and Ellen Smithson have recently retired after numerous years of working as a heart surgeon and pediatrician,
respectively. The Smithsons were unable to have children, so they devoted their lives to helping others through their
professional and charitable activities. Sam is involved in the local "Pantry Pass," an organization that gathers food items for
distribution to the needy. Ellen is involved in her local "Housing for the Homeless," chapter. Over the years they have served
the two organizations as active volunteers and as board members.
The Smithson's professional activities generated high incomes, well in excess of expenses. Prior to retirement, their lifestyle
could be described as comfortably frugal. Over the years, a retirement savings account in the amount of $4,000,000 was
accumulated.
Marcus Medley, CFA is an investment consultant who serves high net worth individuals. During his discussions with the
Smithsons, Sam and Ellen mentioned the following:
We consider our retirement portfolio to be large both in absolute terms and relative to our lifestyle needs.
Our living expenses are estimated to be no greater than $150,000 per year, but we do want to maintain our purchasing
power without eroding the principal of our account.
We are both in good health and have at least another 20 to 25 years of life expectancy. We do not expect any major
medical expenses, either chronic or acute, over the foreseeable future.


We have no debts and are not interested in anything that would require us to borrow.
After we die, we would like to leave the remainder of our portfolio equally to the charities with which we have been involved
all these years. One of our objectives is to maximize the funds transferred.
Although we hope to leave a substantial estate to the charities, we wish to ensure that at least a floor value amount will be
transferred.
Neither one of us has a high tolerance for risk. For the most part, our retirement savings have been in low-risk investment
vehicles. Our investment portfolio decisions have been made in congruence with our desire to leave a legacy for future
generations and to help our fellow man.
We know we could establish a charitable remainder trust but we're not ready to do that yet; we want to stay in control of all
our assets as long as we're able. Besides, our estate probably isn't large enough right now to be subject to death taxes.
We agree with your firm's capital market expectations and the projection that inflation will average 3.25% over the longterm.
We do not want to use any type of derivative security like options or futures - and we would never consider short selling.
During the course of their meeting, Medley asks the Smithsons whether their approach to investing has been passive or
active. Ellen Smithson says "Oh, I'm definitely the passive type - I don't believe in getting too involved, so I let Sam make most
of the decisions on our portfolio. He's done a wonderful job up to now, but I guess it's time we had someone else take an
active role in helping us."
Sam comments, saying "Yes, it's pretty much been up to me. My investment philosophy has been to invest 70% of our assets
in a total return bond fund and 30% in an S&P 500 index fund, thus ensuring that we track their performance fairly closely
while holding down costs. Then I've tried to get a little more juice by investing selectively in individual companies that produce
surgical instruments or products for the cardiovascular field. That way I can leverage my expertise and judiciously use my
limited time for investing."
Later, Medley reviews the Smithsons' personal statements and the latest economic activity forecasts. He then begins to
formulate an Investment Policy Statement (IPS) and some general asset allocation recommendations.

Question #16 of 83

Question ID: 465461

Which of the choices below most closely matches the investment strategies of Ellen and Sam?
ᅚ A) Ellen has no investment approach; Sam has a semi-active approach.
ᅞ B) Ellen has no investment approach; Sam has a passive approach.
ᅞ C) Ellen has a passive approach; Sam has a semi-active approach.
Explanation
Ellen is describing a passive personality type, rather than a passive approach to investing. Sam's investment methodology is
closest to that of semi-active (risk-controlled, enhanced index) managers. He seeks to track an underlying index while trying to
provide extra value by more heavily weighting the medical technology and services sector. (Study Session 9, LOS 20.b)

Question #17 of 83

Question ID: 485088

While writing the risk objective statement, Medley ponders the Smithson's ability and willingness to accept risk. The Smithson's
appear to have the ability:
ᅞ A) to take below-average risk; willingness to take above-average risk.
ᅚ B) to take above-average risk; willingness to take below-average risk.
ᅞ C) and willingness to take below-average risk.


Explanation
Given the data regarding the Smithsons' situation, it appears that they are able to take above-average risks (large absolute
and relative sized portfolio), but are only willing to accept below average risks ("neither of us has a high tolerance for risk").
(Study Session 8, LOS 18.g)

Question #18 of 83

Question ID: 485089

One of the first concepts Medley wants to explain to the Smithson's at their next meeting is the idea of holding an "optimal"
portfolio. Which of the following will dictate the selection of an investor's optimal portfolio?
ᅞ A) Any portfolio lying above the efficient frontier.
ᅚ B) The tangential intersection between an investor's risk and return and the efficient
frontier.
ᅞ C) The global minimum variance portfolio.
Explanation
An optimal portfolio is any set of assets yielding the highest returns for given risk levels (dictated by the efficient frontier).
Assuming the risk free asset is available to invest in then a straight line, the capital allocation line (CAL), would be drawn from
the risk free rate to the efficient frontier touching the efficient frontier at the point of tangency representing the global market
portfolio. The CAL then becomes the efficient frontier. Any point on this line would represent the optimal portfolio combination
of the risk free asset with the global market portfolio resulting in the highest Sharpe ratio (highest return for a given level of
risk). (Study Session 8, LOS 18.r)

Question #19 of 83

Question ID: 485090

According to the Smithson's risk profile, a general asset allocation that would fit well with their objectives is:
ᅞ A) an asset allocation heavily-weighted toward fixed-income to meet their current
income needs and provide for modest growth.
ᅞ B) an asset allocation heavily-weighted toward risk-free securities to meet their current
income needs and minimize the possibility of losing any of the original $4 million.
ᅚ C) a conservative, total return asset allocation to meet their current income and wealth
transfer goals.
Explanation
An asset allocation that focuses on total return would appear to best meet the Smithson's objectives given the apparent
disconnect between ability and willingness to take risk. The Smithson's need to earn a 3.75% return ($150,000/$4,000,000) to
meet their current income needs in today's dollars. To protect their purchasing power, they must also generate an additional
3.25%. A conservative total return approach provides an appropriate balance between meeting their retirement needs and
their goal of maximizing the amount of their charitable estate. The risk-free and modest growth portfolios would not meet all
their objectives. (Study Session 8, LOS 18.g)

Question #20 of 83

Question ID: 485091

Which of the following dynamic asset allocation strategies would be most appropriate for meeting the Smithson's charitable
objectives?
ᅞ A) Buy and hold.


ᅚ B) Constant proportion portfolio insurance strategy.
ᅞ C) Constant mix strategy.
Explanation
A constant mix strategy would have a zero floor value, hence would not be an appropriate strategy for meeting Smithson's
objectives. A buy and hold strategy is not a dynamic asset allocation strategy but is the "do nothing" strategy where once your
initial asset allocation is chosen you do not reallocate but instead just let the allocation fluctuate according to any changes in
the market. (Study Session 16, LOS 31.j)

Question #21 of 83

Question ID: 485092

A constant mix asset allocation strategy assumes that an investor's risk tolerance:
ᅞ A) increases as the portfolio value rises and falls as the portfolio value falls.
ᅞ B) falls as the portfolio value approaches the floor value.
ᅚ C) is constant, regardless of wealth levels.
Explanation
With a constant mix strategy, an investor's risk tolerance is constant, regardless of wealth levels. CPPI assumes that risk
tolerance increases as stocks rise and falls as stocks fall. (Study Session 16, LOS 31.j)

Question #22 of 83

Question ID: 465441

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

ᅞ A) In order to effectively implement a strategic asset allocation strategy, the investor's risk
tolerance must remain constant.

ᅞ B) Tactical allocation is a contrarian investment strategy.
ᅚ C) Strategic asset allocation is a drifting mix strategy.
Explanation
Strategic asset allocation is a constant-mix strategy. It requires that a portfolio is rebalanced in order to maintain a prescribed allocation.

Question #23 of 83

Question ID: 465452

Dynamic asset allocation is most suitable for investors who:
ᅞ A) have insignificant liabilities.
ᅚ B) undertake the asset-liability approach to strategic asset allocation.
ᅞ C) have a long time horizon.
Explanation
Dynamic asset allocation is most suitable for investors who have significant liabilities and utilize the asset-liability approach to
strategic asset allocation.


Question #24 of 83

Question ID: 465502

The following information is available regarding corner portfolios from an efficient frontier.

Asset Class Weights

Corner Expected Exp. Std.
Portfolio Return

Dev.

1

2

3

4

1

6.90%

4.60%

0.00% 12.00% 88.00% 0.00%

2

10.00%

8.64%

0.00% 15.00% 45.00% 40.00%

3

13.00%

12.50% 55.00% 0.00% 45.00% 0.00%

An investor has a spending rate of 8%. If inflation is expected to be 3.50% annually and the cost of earning investment returns
is 0.5%, which of the following represents the correct weight of one of the asset classes that will at a minimum satisfy the
investor's goals of capital preservation in real terms to an investor with a risk aversion value of 4?

ᅞ A) Asset class 2 with weight of 50.00%.
ᅚ B) Asset class 1 with a weight of 42.90%.
ᅞ C) Asset class 3 with weight of 39.00%.
Explanation
r = (1+s)(1+i)(1+c) - 1 = (1.08)(1.035)(1.005) - 1 = 12.34%

This portfolio would lie between corner portfolios 2 and 3. Let w denote the weight of corner portfolio 2, we solve for w in the
following equation:

12.34 = (10.0)(w) + (13.00)(1-w)
w = 0.22

With respect to the asset classes, the weights are then derived as follows:

Weight of asset class 1 = (0.22)(0%) + (0.78)(55%) = 42.90%
Weight of asset class 2 = (0.22)(15%) + (0.78)(0%) = 3.30%
Weight of asset class 3 = (0.22)(45%) + (0.78)(45%) = 45.00%
Weight of asset class 4 = (0.22)(40%) + (0.78)(0%) = 8.80%

Questions #25-26 of 83
Carl Allen and Cliff Hanes are analysts for Tacticon Advisory (Tacticon). Allen and Hanes have been assigned the task of
documenting some of Tacticon's asset allocation techniques. After receiving accolades in a recent trade magazine article
featuring investment firms with innovative trading strategies, their supervisor, Amos Ridley, decides it is time the firm began
formally documenting the firm's proprietary asset allocation process.
Ridley wants Allen and Hanes to record the specifics of Tacticon's investment process for internal use. He also wants them to
compile a document explaining a variety of allocation techniques to be used by the marketing staff and portfolio managers


when working with prospects and clients.
At their first meeting after receiving the assignment, a discussion of strategic and tactical allocation commences. Allen and
Hanes feel confident about the distinction between the two, but are less certain about the differences between asset-liability
management (ALM) versus asset-only approaches to asset allocation.
Hanes states "ALM and asset-only approaches are used for strategic asset allocation. With ALM an investor's optimal asset
allocation is directly related to explicit liability modeling. On the other hand, with asset-only strategies, liabilities only indirectly
impact the return objective."
Allen replies, "I'm not so sure. I thought that tactical, asset-only approaches like immunization and cash flow matching are
more precise than ALM for controlling risk."

Question #25 of 83

Question ID: 465438

Strategic asset allocation:
ᅞ A) involves short-term variations from an investor's normal asset mix.
ᅚ B) establishes a portfolio's long-term asset class exposures by integrating each element
of investment policy with capital market expectations.
ᅞ C) sets a portfolio's asset class exposures to unsystematic risk.
Explanation
Strategic asset allocation establishes a portfolio's long-term asset class exposures by integrating each element of investment
policy with capital market expectations. It affords an investor the ability to control systematic risk exposures by aligning their
risk and return objectives with the actual portfolio of investments. Tactical asset allocation involves adjustments away from the
strategic mix to take advantage of short-term projections of relative asset class performance.

Question #26 of 83

Question ID: 465439

Concerning the discussion between Hanes and Allen about ALM versus asset-only allocation approaches:
ᅞ A) both are correct.
ᅚ B) only one is correct.
ᅞ C) both are incorrect.
Explanation
Hanes is correct: ALM and asset-only approaches are used for strategic not tactical asset allocation. With ALM an investor's
optimal asset allocation is directly related to explicit liability modeling. Allen is incorrect: with asset-only strategies, liabilities
only indirectly impact the return objective. Asset-only approaches are less precise than ALM for controlling risk. Immunization
and cash management are ALM approaches.

Question #27 of 83

Question ID: 465456

Daniel Roe and Loretta Morgan are both potential new clients of Grachek Investment Advisors. A summary of Ellen Grachek's
notes concerning the potential clients are as follows:
Roe stated that he wants to have a positive return on his $500,000 portfolio at all times, and that his required before-tax


return is 7%. On a risk aversion questionnaire, Roe scored an 8, with 10 indicating the highest risk aversion.
Morgan indicated that her $1,000,000 portfolio must generate a 2% return each year in order to meet her living expenses
without making any withdrawals from the portfolio's principal. On a risk aversion questionnaire, Morgan scored a 3, with 10
indicating the highest risk aversion.
Grachek Investment Advisors has four model portfolios that they use for each client. Characteristics for each portfolio are
identified below:
Portfolio Expected Return Standard Deviation
A

5.5%

7%

B

6.0%

8%

C

6.5%

10%

D

8.0%

15%

After reviewing her notes and making some calculations, Grachek makes the following statements regarding each client:
Statement 1: Based on a utility adjusted return of 2.54%, Portfolio B would be the
best choice for Roe.

Statement 2: Using Roy's Safety-First Measure, Portfolio D generates a score of
0.40, and would be the worst choice of the four for Morgan's
portfolio.
Regarding Gracket's statements:

ᅞ A) Statement 1 is incorrect; Statement 2 is incorrect.
ᅚ B) Statement 1 is incorrect; Statement 2 is correct.
ᅞ C) Statement 1 is correct; Statement 2 is correct.
Explanation
Grachek's statement regarding Roe is based on utility-adjusted return.
Utility adjusted return = Up = Rp - 0.005(A)(σ2)
UA = 5.5% - 0.005 (8) (7%2) = 3.54%
UB = 6.0% - 0.005 (8) (8%2) = 3.44%
UC = 6.5% - 0.005 (8) (10%2) = 2.50%
UD = 8.0% - 0.005 (8) (15%2) = -1.00%.
Based on the calculations, Portfolio A would be the best choice for Roe with a utility-adjusted return of 3.54%. Statement 1 is
incorrect.

Grachek's statement regarding Morgan is based on Roy's Safety-First Measure. Morgan indicated that she has a minimum 2%
return.
Roy's Safety First Measure is calculated as: SF = (RP - RMIN)/σP


SF A = (5.5 - 2)/7 = 0.50
SF B = (6.0 - 2)/8 = 0.50
SF C = (6.5 - 2)/10 = 0.45
SF D = (8.0 - 2)/15 = 0.40
Based on the calculations, Portfolio D would be the worst choice for Morgan's portfolio. Statement 2 is correct.

Question #28 of 83

Question ID: 465471

Which of the following would indicate that an asset class is useful for describing the returns of a portfolio?
ᅞ A) The intercept term is significantly different from zero.
ᅚ B) The R-squared of the model is high.
ᅞ C) The error term is high.
Explanation
A high R-squared would indicate that the model explains a good proportion of portfolio returns.

Question #29 of 83

Question ID: 465479

Suzanne Melby, a newly hired analyst for Taylor Capital Advisors, is making a presentation to Taylor's investment committee
about the practical concerns when adding new asset classes to an investment portfolio. In her presentation, Melby makes two
statements:

Statement 1:We have seen from the previous charts that adding international
securities can increase the returns of a portfolio; however, from the
investor's standpoint, risk may be perceived as higher due to the
inclusion of currency, political, and legal risk.

Statement 2:The investment committee has decided that some type of alternative
investment such as hedge funds should be included in all client
portfolios, but the large amounts of capital required and the difficulty
of finding information may prevent us from investing in alternative
investments in some client portfolios.
With regard to Melby's statements, the Taylor Capital Advisors investment committee should:

ᅞ A) agree with Statement 1, but disagree with Statement 2.
ᅞ B) disagree with Statement 1, but agree with Statement 2.
ᅚ C) agree with both Statement 1 and Statement 2.
Explanation
The Taylor investment committee should agree with both of Melby's statements as she has correctly identified some of the


practical concerns when investing in global securities and alternative investments such as hedge funds. The practical
considerations of including global securities in a portfolio relate to risks that an investor does not face with a domestic-only
portfolio such as currency, political, and legal risks. Even if there are diversification benefits from including global securities, a
portfolio manager needs to consider that the investor would be exposed to risks that they would not otherwise be exposed to.
Melby's second statement is also correct as a lack of information, large amount of required capital, and the need to carefully
select out-performers are all drawbacks to alternative investments that potentially could prevent the investment manager from
using them in client portfolios.

Question #30 of 83

Question ID: 465484

The phrase "conditional return correlations" can best be defined as:
ᅚ A) correlation that depends upon market volatility.
ᅞ B) returns that are conditional upon the correlation used.
ᅞ C) correlation that increases during times of financial crises due to measurement bias.
Explanation
The observation that correlations increase during financial crises is inconsistent with the assumption that correlation and
standard deviation remain stable over time. One solution to this problem is run mean variance analysis and optimize the
portfolio over two sets of data: one set assuming normal conditions of higher returns with lower correlations and volatilities plus
another set assuming lower returns with higher correlations and volatilities. In other words return and correlation are
conditional on volatility. The other two answers are less accurate. One of the answers says return is conditional on correlation,
that answer is less accurate. Another answer says correlations increase during crisis, while this is a true statement it is not a
definition of conditional return correlations.

Question #31 of 83

Question ID: 465453

What is the major difference between dynamic asset allocation and static asset allocation? Dynamic asset allocation:
ᅞ A) considers asset and liability management simultaneously while static asset
allocation does not.
ᅞ B) considers more than one asset class while static asset allocation only considers one
asset class at a time.
ᅚ C) takes a multi-period view of the investment horizon while static asset allocation does
not.
Explanation
Dynamic asset allocation takes a multi-period view of the investment horizon while static asset allocation does not. Dynamic
asset allocation and static asset allocation both can be used for asset only or asset-liability approaches to strategic asset
allocation. Both dynamic and static asset allocation approaches consider more than one asset class.

Question #32 of 83

Question ID: 465503


Based on the following information, compute the weight of US bonds in an efficient portfolio with an expected return of
13.50%?

The following are the long-term capital market expectations:

Asset Class

Expected
Return

Correlations
Exp. Std. Dev.
1

2

3

4

5

1

US Equity

12.00%

16.00%

1.00

2

US Bonds

8.25%

6.50%

0.32 1.00

3

Intl Equities

14.00%

18.00%

0.46 0.22 1.00

4

Intl Bonds

9.25%

12.25%

0.23 0.56 0.32 1.00

5

Alt Inv

11.50%

21.00%

0.25 0.11 0.08 0.06 1.00

The details of each corner portfolio are given below.
Asset Class Weights

Corner Expected Exp. Std. Sharpe
Portfolio Return

Dev.

Ratio

1

2

3

4

5

1

14.00%

18.00%

0.639

0.00% 0.00% 100.00% 0.00% 0.00%

2

13.66%

16.03%

0.696

0.00% 0.00% 86.36% 0.00% 14.00%

3

13.02%

13.58%

0.775 21.69% 0.00% 56.56% 0.00% 21.76%

4

12.79%

13.00%

0.792 21.48% 0.00% 52.01% 5.24% 21.27%

5

10.54%

8.14%

0.988

9.40% 51.30% 26.55% 0.00% 12.76%

6

8.70%

6.32%

0.981

0.00% 89.65% 4.67% 0.00% 5.68%

ᅞ A) 6.25%.
ᅚ B) 0.00%.
ᅞ C) 3.75%.
Explanation
The expected return of 13.50% lies between corner portfolios 2 and 3 with expected returns of 13.66% and 13.02%. Since
both these corner portfolios have no exposure to US bonds, the weight of US bonds in a portfolio which is the weighted
average of portfolios 2 and 3 would also be 0%.

Alternatively:
We solve for w in the following equation:

13.50 = w(13.66) + (1-w)(13.02)
w = 0.75

In other words, the efficient portfolio with an expected return of 13.50% has 75% weight of corner portfolio 2 and 25% weight
of corner portfolio 3. With respect to the US bonds asset class, the weight is then derived as follows:

Weight of US bonds = (0.75)(0%) + (0.25)(0%) = 0%


Question #33 of 83

Question ID: 465490

The first step in the portfolio construction process is called:
ᅞ A) tactical asset allocation.
ᅚ B) strategic asset allocation.
ᅞ C) capital market expectation.
Explanation
The steps in the asset allocation process are:
1. Determine the investor's risk, return, and constraints.
2. Formulate long-term capital market expectations.
3. Determine the mix of assets (allocation) that best meets the objectives of the IPS.
4. Monitor the portfolio.
5. Adjust the portfolio as necessary for strategic or tactical asset allocation.
Strategic asset allocation is the first step in the portfolio construction process which is step 3 above. Tactical asset allocation is
the subsequent deviation from the strategic asset allocation based on short-term capital market expectations. Capital market
expectations are used for the generation of the efficient frontier used in step 2 above which occurs before the portfolio
construction takes place.

Question #34 of 83

Question ID: 465476

James Mason is the Chief Operating Officer of the Homeless Mission Foundation (HMF), a foundation with the purpose of
providing food, clothing, and shelter for homeless individuals. Mason is currently in the process of preparing a report to HMF's
board recommending an asset allocation for the foundation. This year, Mason estimates that HMF's operating budget will be
$2.75 million. In order to assist with preparation of his report, Mason has compiled the following data.
The market value of the foundation is currently $50,000,000.
The cost for providing services to homeless individuals is expected to rise at a rate of 3.0% per year.
The board would like to maintain a cash cushion equal to half of the estimated operating budget in order to meet any
unexpected expenses.
Management fees for the foundation are estimated to be 0.40%.
The board is willing to accept market risk in order to meet its long-term objectives, but the board wants to accept shortfall
risk (defined as expected return minus two standard deviations) of no more than 15%.
Mason must recommend one of three different portfolios to the board. Mason's choice of portfolios is shown below:
Portfolio A

Portfolio B

Portfolio C

Large cap U.S. stocks

24%

30%

20%

Small cap U.S. stocks

10%

5%

13%

International - Developed market equities

5%

13%

5%

International - Emerging market equities

5%

5%

10%

U.S. Corporate bonds

25%

20%

17%

U.S. Treasury bonds

20%

16%

21%

Asset Class


Real estate

5%

10%

10%

Cash

6%

3%

4%

TOTAL

100%

100%

100%

Expected Annual Total Return (%)

7.85%

9.20%

8.80%

Expected Standard Deviation (%)

11.15%

12.10%

12.20%

In his report, Mason is going to recommend a portfolio based on 3 criteria: liquidity needs, return requirements, and shortfall
risk. Which of the portfolios should Mason recommend?

ᅚ A) Portfolio B.
ᅞ B) Portfolio C.
ᅞ C) Portfolio A.
Explanation
Liquidity requirements - Mason's notes stated that the portfolio needs to maintain cash equal to 50% of the estimated
operating budget. This means that cash in the portfolio needs to be equal or greater than [(2.75)(0.5)]/50 = 2.75%. All of the
portfolios meet the liquidity requirement.

Return Requirements - Spending is equal to (2.75/50) = 5.5%. With inflation of 3.0% and management fees of 0.40%, the
return requirement is (1.055)(1.004)(1.03) -1 = 9.10%. Only Portfolios B meets the return requirement.

Shortfall risk - The shortfall risk for each portfolio is as follows:
Portfolio A: 7.85% - (2 × 11.15%) = -14.45%
Portfolio B: 9.20% - (2 × 12.10%) = -15.00%
Portfolio C: 8.80% - (2 × 12.20%) = - 15.60%
Therefore, only Portfolios A and B meet the shortfall risk requirement.

Since Portfolio B is the only one to meet all three requirements, Portfolio B is the best choice.

Question #35 of 83

Question ID: 465434

Strategic asset allocation reflects what systematic risk exposure?
ᅞ A) Long-term systematic risk exposure.
ᅞ B) Asset class systematic risk.
ᅚ C) Investor's desired systematic risk exposure.
Explanation
Strategic asset allocation reflects the investor's desired systematic risk exposure.

Question #36 of 83
Which of the following does NOT accurately reflect a statement describing the resampled efficient frontier?

Question ID: 465494


ᅞ A) At each level of return the most efficient of the simulated efficient portfolios is
at the center of a distribution.
ᅚ B) A single portfolio with specific asset class weights at each level of return.
ᅞ C) A portfolio may be considered statistically equivalent if the manager's portfolio is within
a 90% confidence interval of the most efficient portfolio.
Explanation
A single portfolio with specific asset class weights at each level of return describes traditional mean variance optimization. The
other answer choices describe the resampled efficient frontier where Monte Carlo simulation is used to create an efficient
frontier at each return level and run thousands of times resulting in an efficient frontier that is the result of an averaging
process. The efficient frontier becomes a blur rather than a single sharp curve. At each level of return, the most efficient of the
simulated efficient portfolios is at the center of the distribution.

Question #37 of 83

Question ID: 465475

Which of the following characteristics of asset classes is most desirable? Asset classes should:
ᅞ A) be negatively correlated.
ᅞ B) have an index.
ᅚ C) be mutually exclusive.
Explanation
One of the desired characteristics of asset classes is that they should be mutually exclusive. They also should not be highly
(positively or negatively) correlated with each other.

Question #38 of 83

Question ID: 465504

Based on the following information, compute the weight of international bonds and international equities respectively in an
efficient portfolio with an expected return of 12.50%?

The following are the long-term capital market expectations:

Asset Class

Expected
Return

Correlations
Exp. Std. Dev.
1

2

3

4

5

1

US Equity

12.00%

16.00%

1.00

2

US Bonds

8.25%

6.50%

0.32 1.00

3

Intl Equities

14.00%

18.00%

0.46 0.22 1.00

4

Intl Bonds

9.25%

12.25%

0.23 0.56 0.32 1.00

5

Alt Inv

11.50%

21.00%

0.25 0.11 0.08 0.06 1.00

The details of each corner portfolio are given below. The risk free rate is assumed to be equal to the T-bill rate of 3.00%.
There is also a restriction on short sales.


Corner Expected Exp. Std. Sharpe
Portfolio Return

Dev.

Ratio

Asset Class Weights
1

2

3

4

5

1

14.00%

18.00%

0.639

0.00% 0.00% 100.00% 0.00% 0.00%

2

13.66%

16.03%

0.696

0.00% 0.00% 86.36% 0.00% 14.00%

3

13.02%

13.58%

0.775 21.69% 0.00% 56.56% 0.00% 21.76%

4

12.79%

13.00%

0.792 21.48% 0.00% 52.01% 5.24% 21.27%

5

10.54%

8.14%

0.988

9.40% 51.30% 26.55% 0.00% 12.76%

6

8.70%

6.32%

0.981

0.00% 89.65% 4.67% 0.00% 5.68%

ᅚ A) 4.56%, 48.70%.
ᅞ B) 6.12%, 46.29%.
ᅞ C) 3.75%, 52.00%.
Explanation
The expected return of 12.50% lies between corner portfolios 4 and 5 with expected returns of 12.79% and 10.54%. We solve
for w in the following equation:

12.50 = w(12.79) + (1-w)(10.54)
w = 0.87

In other words, the efficient portfolio with an expected return of 12.50% has 87% weight of corner portfolio 4 and 13% weight
of corner portfolio 5. With respect to asset classes, the weight is then derived as follows:

Intl bonds = (0.87)(5.24%) + (0.13)(0) = 4.56%
Intl equity = (0.87)(52.01%) + (0.13)(26.55) = 48.70%.

Question #39 of 83

Question ID: 465499

Shad Reed is on the Board of Trustees for the Wesley Ridge World Hunger Organization. The primary role of the organization
is to oversee a large endowment fund that was originally established in 1995 as the Wesley Ridge U.S. Hunger Fund to
provide food to low income children in the United States. Recently, the original donor for the endowment has died and
provided the fund another $200 million in his will and broadened the scope of the fund to provide food for hungry children all
over the world. With the new addition, the endowment's assets are currently valued at $600 million. When the fund was
originally established, the spending rate was 5%; however, with the broader scope, the payout has increased to 6%. Also,
since funds are going to be distributed to other countries, the board has determined that approximately 25% of the
foundation's annual payout will be in the foreign currencies of other countries. The fund's investment policy statement which
has been revised by the board is shown below:

Return Objective

Accounting for inflation of 2.5% and the new spending rate of 6%, the return requirement for the plan is
8.5%. A total return approach is appropriate.

Risk Tolerance

Above average, although risk tolerance has declined due to higher spending needs.

Liquidity

The endowment has minimal operating expenditures - liquidity requirements are low.


Time Horizon

Long-term

Legal/Regulatory N/A
Taxes

N/A

Unique
Considerations

N/A

The board has consulted with an investment advisor to discuss changes to the endowment's current asset allocation which is
shown below:

Asset Class

Expected Standard

Allocation (%)

Expected Return

Cash

2%

3.0%

2%

Intermediate-term U.S. Treasury bonds

28%

5.5%

7%

Foreign Government Bonds

8%

6.5%

10%

U.S. equities

50%

9.5%

18%

International equities

7%

11.0%

23%

Venture Capital

5%

19.0%

38%

Deviation

Which of the following sets of recommendations would be most appropriate for the endowment fund?

ᅞ A) Decrease the allocation to U.S. Equities, decrease the allocation to
international equities, increase the allocation to foreign government bonds,
and increase the allocation to intermediate-term U.S. Treasury bonds.
ᅚ B) Increase the allocation to foreign government bonds, increase the allocation to
international equities, keep the allocation to cash the same, and keep the allocation to
venture capital the same.
ᅞ C) Increase the allocation to cash, decrease the allocation to U.S. equities, decrease the
allocation to international equities, and increase the allocation to venture capital.
Explanation
Since liquidity needs are low, the allocation to cash is appropriate. Since payments are going to be made in foreign currencies,
it makes sense to increase the allocation to both foreign bonds and international equities. Especially if these asset classes
have low correlation with other assets in the portfolio, increasing their weight in the portfolio could reduce risk, although their
higher standard deviations suggest only moderate increases. Since the fund has a long time horizon and above average risk
tolerance, the allocation to venture capital is fine given its above average returns and likely low correlation with other assets in
the portfolio.

Question #40 of 83

Question ID: 465485

Which of the following is least accurate regarding an emerging market stock and country where the country has recently been
integrated into the world markets?
ᅞ A) The market microstructure becomes more efficient as transaction costs fall,
liquidity increases, and information flows more freely.


ᅞ B) Capital costs will fall with higher stock prices and lower risk fueling economic growth.
ᅚ C) Portfolio diversification benefits increase as the stand-alone risk of the stock
decreases.
Explanation
The diversification benefits of adding a recently classified developed market stock to a diversified stock portfolio decreases
because the correlation of the recently classified developed market stock with the global markets increases.

Question #41 of 83

Question ID: 465497

Corri Morgan is an investment advisor for Izaguirre Investment Management (IIM). Morgan is reviewing the account for Brian
and Nicole Herbster.

Brian and Nicole are both age 65, and have one daughter, Andrea, age 18. The Herbsters are recently retired from Tucker
Technology Inc., a large manufacturer of microprocessors for a variety of applications. Andrea is an aspiring finance student
and would like to attend a prestigious university to pursue a degree in finance. The tuition at the University costs $40,000 per
year, but Andrea's strong academic performance in high school allowed her to earn a scholarship covering half of the tuition.
The Herbsters have expressed a desire to fund the amount of the college education not covered by the scholarship, as well as
leave a large inheritance to Andrea at their death. During their careers, the Herbsters earned relatively high incomes, and
were able to save approximately 10% of their income each year. With regard to their portfolio, they say they prefer
investments that have minimal volatility. Their current investment portfolio is valued at $1.2 million.

The investment policy statement for the Herbsters is shown below:

Return Objective

The Herbster's income requirement is $6,000 monthly. Total return requirement is $72,000 /
$1,200,000 = 6%.

Risk Tolerance

Ability to take on risk: average. Willingness to take risk: below average

Liquidity

Need cash each year for the next four years to fund college education.
3 stages. Stage 1, funding daughter's college tuition. Stage 2, retirement. Stage 3, after death -

Time Horizon

inheritance for daughter.

Legal/Regulatory

N/A

Taxes

Little need to defer income.

Unique
Considerations

Desire to fund daughter's college education.

The Herbster's current portfolio is shown below:

Expected
Allocation

Expected

Expected

(%)

Return

Yield

Asset/Fund

Standard
Deviation

Tucker Technology Common
32%
Stock

19.0%

0.5%

28%


Money Market Fund

2%

2.5%

2.5%

2%

Diversified Bond Fund

30%

6.5%

5.5%

8%

Large capitalization equities

15%

9.5%

2.0%

16%

Emerging market equities

15%

16.0%

1.0%

26%

6%

19.0%

0%

N/A

Undeveloped commercial
land

After reviewing the notes on the Herbster's, Morgan reviews recommendations complied by Todd Irons, a fellow portfolio
manager with IIM. Irons' recommendations include the following:
Recommendation 1: Reduce the weighting in Tucker Technology common stock - the large position exposes the
portfolio to unnecessary security specific risk.
Recommendation 2: Increase the allocation to the Diversified Bond Fund in order to increase income and
decrease volatility.
Recommendation 3: Increase the allocation to Large Capitalization Equities to provide growth.
Recommendation 4: Maintain the allocation to emerging market equities due to their high returns.
Recommendation 5: Maintain the allocation the undeveloped commercial land due to its low correlation with
other assets in the portfolio.
After reviewing Irons' recommendations, Morgan should agree with:

ᅞ A) Recommendations 1, 2 and 4 only.
ᅞ B) Recommendations 1, 3 and 5 only.
ᅚ C) Recommendations 1, 2 and 3 only.
Explanation
Morgan should agree with Recommendations 1, 2, and 3. The allocation to emerging market equities is probably too high
given the Herbster's preference for low volatility investments. Also, the allocation to undeveloped commercial land would be a
cash drain on the Herbster's portfolio due to payments for taxes, etc. The Herbsters need income and liquidity to meet
ongoing portfolio disbursement requirements and the undeveloped commercial land provides neither.

Question #42 of 83

Question ID: 465455

Kimbo Slice has several different places where he has assets in which he manages as separate accounts such as his checking
account which he uses for short term cash and emergency needs, his 401(k) account for retirement, and his children's college
fund. In his 401(k) he owns a small cap stock in a company which makes catheters to be used in experimental cancer
treatment in which the catheter is used to deliver cancer killing drugs to hard to reach tumors in the body. The stock has
recently taken a downturn in price due to the FDA not approving their most recent catheter. As a result of the downturn in
price, Slice purchases more of the stock in hopes of recouping his losses at some future time. Slice's management of his
portfolio is indicative of:
ᅞ A) money illusion and fear of regret.
ᅚ B) mental accounting and loss aversion.
ᅞ C) asset allocation and pyramiding.


Explanation
Slice is exhibiting mental accounting by having separate accounts for his assets which he manages each account separately
for a specific purpose and does not manage his assets as a complete portfolio for asset allocation purposes. He is also
exhibiting loss aversion by not accepting the loss on the stock which is also leading to risk seeking behavior by buying more of
the losing stock. Loss aversion is similar to fear of regret which also results in holding onto loser too long because you regret
selling at a loss, but fear of regret does not lead to risk seeking behavior as loss aversion can. Also fear of regret tends to lead
to safer investments and undiversified portfolios as can be seen in mental accounting, too. Pyramiding is similar to mental
accounting, but pyramiding is where a person layers their investments in the shape of a pyramid in which their most pressing
and important needs are on the bottom layer in the most conservative investments. As one moves up the pyramid,
investments move more towards equities and riskier investments until you get to the top which reflects investment for wish list
type items. Money illusion deals with inflation and thinking that you have more money if your investments (or income) went up
by the same amount as inflation.

Question #43 of 83

Question ID: 465451

Which one of the following most closely matches an advantage of the asset-liability approach over the asset only approach to
strategic asset allocation?
ᅚ A) Liability funding is more accurately controlled.
ᅞ B) Liabilities and assets are highly correlated.
ᅞ C) Asset classes have different systematic risk exposures.
Explanation
The asset-liability approach to strategic asset allocation is desirable because liabilities are more accurately controlled.

Question #44 of 83

Question ID: 465480

Wahid Sedique, portfolio manager with Fort Meigs Investment Advisors is discussing the practical and theoretical benefits of
adding additional asset classes to client portfolios with his colleague Elizabeth Alvarez. In their conversation Sedique states,
"From a practical standpoint, adding emerging markets to a portfolio consisting of developed U.S. and International equities
provides valuable diversification in the event of a global crisis due to their low correlation with other asset classes." Alvarez
replies, "I think we should include U.S. TIPS in our client allocations because they are a liquid and virtually risk-free way to
increase portfolio cash flows in the event of rising inflation."
With respect to their statements:

ᅞ A) Sedique is incorrect; Alvarez is incorrect.
ᅞ B) Sedique is correct; Alvarez is correct.
ᅚ C) Sedique is incorrect; Alvarez is correct.
Explanation
Sedique's statement is incorrect. Although emerging markets have been shown to have a low correlation with other asset
classes, and thus, diversification benefits, in a global crisis, the correlation between emerging markets and developed markets
tends to be high. In other words, the diversification benefit of emerging markets is weak at exactly the time when the investor


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