Question

Read the article ‘How stocks test young investors’.

When deciding how much to invest in stocks, Mr Kitces says, your first consideration should be how comfortable you are with risk to begin with. This is what’s known as your ‘risk tolerance.

’ The problem: Investors — particularly young ones — are notoriously bad at predicting how much money they are willing to lose. Compounding the problem, young investors, due to their lack of experience in the markets and overall financial illiteracy, tend to misjudge how much risk they are actually taking with their portfolios, says Mr Kitces.

‘Most of the time they underestimate how much risk they are taking and overestimate how much risk they’re comfortable with,’ he says.

The best measure of your risk tolerance — and the true test of what kind of investor you are — is how you actually behave in a bear market, says William Bernstein, an investment manager at Efficient Frontier Advisors in Eastford, Conn., and the author of several books on investing.

That’s why Mr Bernstein recommends that young investors start with a portfolio that’s roughly 50% stocks (split evenly between foreign and domestic) and 50% US bonds until they experience their first bear market. ‘Then you see how you respond and you learn what your actual risk tolerance is,’ he says. If you panic and retreat to cash, you may want to dial down your stockholdings to 30% or 40%, he says. Conversely, if you continue systematically investing, you may want to go 60% or 70% stocks.

The more investing experience and assets you accumulate, he says, the more risk tolerant you are likely to become. ‘I think there is a wealth effect’ that makes you more willing and able to handle risk, he says.

But there is no need to swing for the fences, he says. Most 25- year-olds would do just fine if they invested at least 15% of their salary every year until retirement in a portfolio composed of just three index funds — a US total stock-market index fund, an international total stock-market index fund and a US total bondmarket index fund--held in equal proportions and rebalanced annually, he says. (He lays out why in his newest booklet, If You Can: How Millennials Can Get Rich Slowly, which can be downloaded free for Kindle from Amazon.com through Tuesday.)

As simple as it sounds, though, it’s not easy for young adults to save that much consistently, especially when they also need to pay down debt and establish a separate cash account for emergencies, he says.

Indeed, for many young people, ‘their 401(k) becomes their emergency fund by default,’ says Rob Arnott, chairman of investment firm Research Affiliates. ‘It shouldn’t, but it does.’Young adults are more vulnerable to the vagaries of the job market, more likely to get laid off when markets swoon, and more apt to cash out their 401(k)s when switching jobs, he says.

Required:

1. Mr Bernstein said that the more investing experience and assets you accumulate, the more risk tolerant you are likely to become. If you panic and retreat to cash, you may want to dial down your stockholdings to 30% or 40%. Conversely, if you continue systematically investing, you may want to go 60% or 70% stocks.

In addition to what Mr Bernstein mentioned above, discuss two actions that you would take to become a more risk tolerant investor assuming you are holding a well-diversified portfolio of Bond ETF and Stock ETF. Explain whether your actions violate the Modern Portfolio Theory in terms of portfolio efficiency.

Answer 1

According to modern portfolio theory we need to construct a portfolio with maximum returns for a given amount of risk.

In order to become a risk tolerant investor we will have to take risks invest more in Stock FTFs at same level of return. Another method will be accepting lower returns at same level of risk hence reducing bomd investments

These actions will be in violation to the modern portfolio theory as the theory assumes that all investors are risk averse and hence any investor will accept highest returns for given amount of risks.