Asset Allocation and Risk Reduction Strategies

This is a cumulative LOS that combines all of the previous readings about insurance, asset allocation, and individual risk management. A few key points to take away are:

• Investors and managers must consider total wealth in the asset allocation decision in order to take the appropriate amount of systematic risk (specific to the portfolio but considering the effects of HC).
• Non-systematic risk should be managed to appropriate levels using diversification of FC and insurance.

Examples

A doctor just entering the medical profession may have very large amounts of human capital and relatively none, or even negative financial capital if they relied heavily on student loans. It goes without saying that the asset allocation of the financial capital in this case, is not a major concern. The human capital component may be insured via life and/or disability insurance. It may be prudent to prioritize paying down debts and higher living expenses at this stage and begin saving for retirement at later career stages when debt has been controlled and some financial capital has built up.

A wealthy individual just entering retirement will need to prioritize the asset allocation of financial capital. It will be important at this stage to shift risk from equity markets and more risky assets to steadier fixed-income securities. Longevity risk comes into the picture at this stage, and annuities can help mitigate this issue. More financial capital means higher property and liability insurance needs. Conversely, with no human capital left, disability, and life insurance needs diminish.

Question

Which of the following is least likely an effective tool for managing total wealth risk:

1. Adjusting human capital.
2. Diversifying financial capital.
3. Purchasing insurance policies.

Solution:

The correct answer is A.

Human capital is largely unchangeable. Unless an individual goes back to school or acquires new professional skills, it tends to stay constant. Purchasing an insurance policy or changing the asset allocation of a portfolio of financial assets is by comparison, much easier.

B is incorrect. Diversifying financial capital involves spreading investments across different asset classes to reduce the risk associated with individual investments. It is an effective tool for managing financial risk and protecting your wealth.

C is incorrect. Purchasing insurance policies, such as life, health, or property insurance, is an effective tool for managing various risks, including financial risk. Insurance provides financial protection in case of unexpected events.

Reading 9: Risk Management for Individuals

Los 9 (k) Recommend and justify appropriate strategies for asset allocation and risk reduction when given an investor profile of key inputs