Investment Portfolio Modelling - Case Study Example

 Reading Header: Investment Portfolio Modelling Abstract Mr. Fortunate is a 30 year old healthy man, who earns highly though contracted as a financial risk advisor wishes to make some tangible investments to cater for his future needs and plans. This include catering for own and his wife’s retirement plans and educational funds for his two children aged two and three years of age. His average annual income is £100,000; however his wife has recently been laid-off from her job. Mr. Fortunate’s wife managed to obtain a redundancy payment of £12,000 of which she intends to establish a domestically based career as a writer. The couple owns a house valued at £200,000 purchased five years ago but with an annual repayment mortgage of £130,000 for 20 years. The recent job loss by Mrs. Fortune has however caused some consternation to the couple in regards to the mortgage repayment, however new rate reductions and her send-off package have eased the future trepidation. The Fortunates, who are keen sailors, have made some savings of £15,000 towards the purchase of a yacht presumably to sail around the world. The projected pricing and equipping of the yacht will cost them a current price of £150,000. The global voyage will take a whole year on a budget of approximately £20,000. Mr. Fortunate has in the meantime inherited £100,000 in cash and a portfolio of shares which had a cumulative total purchase price of £1,923,475.00 (See, Figure 3). The cash fund (£100,000) has been deposited in a building society account that attracts an interest of 1.50% annually. For the Fortunates to realize their dreams of repaying fully their mortgage, the purchase of a yacht, catering for the children education needs, and accumulate a comfortable retirement package, we have designed a solid investment plan that will guarantee their future life. Introduction Investment decisions are often undertaken with an expectation of complimentary rewards in the future. The opportunity cost forfeited on present expenditure and associated risks are sacrificed with the anticipation of commensurate large return. There are many factors considered when designing an investment portfolio. Davis (2008) highlights the cost of capital gains in terms of taxable accounts, secondary tax brackets, disposable income, entry into tax-qualified accounts, ages of investors, period remaining for the investor to retire, risk forbearance, bias towards particular investment funds managers, penchant for certain investment accounts, affinity to particular access rates on equity allotments, inclination to other investments items like merchandise, volatile accounts, and the possibility of future injections of funds. (Davis, 2008) For the Fortunate family, their goal of attaining financial freedom or returns and risk tolerance must however contemplate a number of portfolio constraints. These include liquidity needs or cash and assets to cover their daily expenditure. These encompass the fixed income investments which are easily accessible. Anther vital factor is time horizon of their investment fund since the longer the period, the more solid or risk it can tolerate risk exposure. Taxation is another issue that influence the return objective as some assets are more heavily taxed than others. The Fortunate family must therefore shun investing in these overly oversubscribed assets as they trade at a premium hence offset any initial advantage accrued. In the same vein, the couple must adhere to ethical, legal, and regulatory obligations to avoid future pitfalls that befall illicit behaviour. Generally an investment portfolio returns are determined by the nature or ratio of the particularly risky accounts as counteracted by the risk-free assets or investments. The risky ventures encompass equities, merchandise, real estate, gold, hedge funds, and private equity. The risk-free investments are those short-range premium fixed income accounts like bonds, CD's or treasury bills, papers, or bonds. Although the latter offers a more concrete investment vehicle, the former though plagued by high risks nonetheless proffer higher returns to the investor but may paradoxically lead to heavy losses. Hence most investors delicately balance their investments between the high risks volatile equity markets as opposed to the more solid fixed income markets. To effectively compute the Fortunates investments, we can project the retirement age for Mr. Fortunate at age 60, while that of Mrs. Fortunate at age 65. The current total annual income for the family is £100,000 plus Mrs. Fortunate’s redundancy payment of £12,000, the cash inheritance of £100,000, and the equity fund of £1,923,475.00, hence all totalling to £2,135,475. Their obligations are: annual repayment mortgage of £130,000 for 20 years, a current yacht valuation of £150,000 (less 15,000 already saved) or 150,000-15000 = £135,000, an expense budget of £20,000, all totaling to £285,000. To save for their two children’s fund, the couple needs a total of £500,000 tuition fees. Adding a retirement a consolidated saving of £15,000 annually or £900,000 for thirty years, adds up to a grand total of £1,685,000. In view of their inherited equity fund, the couple already enjoys a surplus saving at current rates totaling £450,475. However due to the volatile nature of the contemporary global markets, the couple will not retire early but rather continue with their prudent investment plans as outlined below. The couple should leave inheritance equity fund intact but initiate a fresh investment vehicle by utilising the cash fund in diverse investments. To accumulate a sizable retirement package, the couple must save at least ten percent of their income or £15,000 annually. Using a moderate and conservative rate of return (3.9 percent), their cash fund can generate: 100,000 × 3.9% (30) = £117,000 totalling to £217,000 The couple can similarly add on their savings after fully repaying their mortgage by the twentieth year while an annual saving of £13,500 will ensure a full repayment for the yacht. The balance of the funds for the ten and twenty years respectively can be utilised in their children’s educational fund plus health and life insurance, approximately £30,000 and £13,500 respectively totalling to: 30,000 × 10 and 13,500 × 20 i.e. 300,000 + 270,000 = £570,000 The diversification of an investment portfolio is held by most analysts to be the most prudent in the enduring adage of ‘Do not put your eggs in one basket’. However some economists ranging from the ‘Father of Economics’ John Maynard Keynes(1934) to the modern ‘Oracle of Omaha’ or Warren Buffet do not subscribe to this stratagem. They argue that it’s wiser to concentrate on those accounts that one is more conversant with than just random indiscriminate diversification. This view is shared by Benartzi and Thaler (2001), and (Brown et al, 2007) with latter suggesting majority of investors follow a ‘naïve diversification strategies’, like uniformly dividing contributions transversely to all available assets or a “1/n” strategy. Warren Buffet the world second richest man has successfully targeted only those companies with a competitive edge or operating a business franchise, including Disney, Coca Cola, Gillette, among others. The imprudent behaviour of blind ‘investment diversification’ is exemplified by the failure of over 20 percent managed unit trusts (in the UK) to outperform the index market frequently. While allotting their equity portfolio, the Fortunates family should therefore critically evaluate specific stocks that are normally effectively competitive while avoiding the usual ‘blue chip’ low yielding stocks. The couple must balance between the high risk investment instruments and guaranteed investment products. Some industries though endowed with high turnovers are volatile and not conducive for a solid portfolio, including the airline, energy, agricultural, banking, among others. The most flexible passive portfolio is made up of two major allotments, one allotted to equities or investments in the stock market; and the other portion is assigned to the bond market. Figure 1   Mix   100% Fix.   20/80%  40/60%  60/40% 80/20% 100% Eq. Ann. Ret.     8.39     9.24     10.09    10.94    11.79    12.64    S.D.     6.61     7.04      8.94    11.62    14.65    17.85 Dimensional Fund Advisors, (DFA). Organisations usually evaluate their capital investment projects by estimating their ‘net present value’ (NPV), hence it’s therefore prudent to invest in projects that have a positive NPV. Most investment decisions or approaches are based on Markowitz’s theorem on mean-variance efficient scope assumed to signify the highest expected return for a given variance (Markowitz, 1952). However McVean (2000) and April (2002) dispute the veracity of this model arguing that it lacks a normal distribution pattern hence cannot reflect risk accurately. April (2002) nevertheless attributes the popularity of Markowitz’s stratagem to the lack of any other appropriate technique to effectively estimate risk variance. The CAPM alludes that it is only non-diversifiable risks that are rewarded and to minimise or optimise the risk-return for the Fortunes, the added spread or diversity of depicted by additional assets reduce the exposure. Expected return = risk free return plus risk premium By using the Capital asset pricing model developed by Sharpe (1964) and Lintner (1965), the we can project or calculate the Fortunates portfolio efficiently based on a single index as the expected return will be dependent on the weighted average of the diverse securities (Singla, 2006). Thus: Ri = α+ β Rm Whereby: Ri = Security Return β=Relationship of security with Common Index Generally Market Index Rm =Market Index α =Risk free return The optimum asset pricing is arrived at when it corresponds to the CAPM discounted rate. If it exceeds the computed price the asset is assumed to be overvalued and vice versa if lower. To maximise his 100,000 inheritance, Mr. Fortunate can also utilise the financial experts Golden Portfolio Balancing Rule: ‘Reduce your age from 100. Resulted percentage of your total money should go to the high risk; high growth investments and rest should invest to guaranteed instruments’ (Sherin, 2009, p. 1). This implies that individuals should accrue and balance their investment portfolio while early. Thus, by the individual’s retirement age, the portfolio will have accumulated an utmost debt and least equity exposure, preferably 90 percent debt and only ten percent in equity (See Figure 4). For Mr. Fortunate who is just 30 years of age, the appropriate retirement age should be at 60 years. Using Sherin (2009) technique, the debt investment amount calculation formula is: Total Amount*Age/60 and minus 10 percent from the result. Thus: (£100,000×30/60) - 10% Equity investment calculation made by the formula: Total Amount - Debt (received as per above calculation). Hence: Debt investment: 100,000*30/60 = 50,000.00 and less 10 percent gives the a Debt Investment value of 45,000.00/- The time-weighted internal rate of return (TWIRR) calculation of a portfolio investment return is preferable as it takes into account the time value of money. The technique is better than the cash-weighted return (e.g., turning £500 into £1,500 is a (1,500-500)/500 = 200 percent return) as it computes the compound annualized growth rate, requiring only the date and cash inflow. Consequently, it is imperative to that a portfolio investment fund performance and results be evaluated to other methods. These techniques include: a relevant stock market index (for Mr. Fortunate the London Stock Exchange’s FTSE 100 index); an age group assessment for generational assessment (consider a comparable age group; and a benchmark asset portfolio of comparable funds. Conclusion Based on the contemporary market volatility and the Fortunates’ varied expenditure for the mortgage repayment, yacht savings, retirement, and children education fund, its therefore our considered opinion that the couple employ an investment mix overweight in cash and short-range, premium bonds and other fixed-income stocks. After the expected defrayal of the yacht, and later the mortgage, we recommend the Fortunates to veer out to a portfolio that is divided into 34 percent equity FTSE 100 stocks, 18 percent international equities (European and U.S. stocks), 20 percent in fixed income like treasury and corporate bonds, ten percent in cash, and 18 percent in an assortment of choice chattels, like gold, real estate, private equity, and risk-free assets, hedge funds or exchange-traded funds holding higher-yield mortgages (Foust, 2009). A diversified portfolio management although advisable should be judiciously practised, with the assets allotments applied using the Sherin (2009) model of Total Amount*Current Age/Retirement Age (less10 percent from the result). Various techniques are applicable to calculate the projected investment returns; hence the Fortunate can comfortably anticipate a productive future devoid of minimal financial trepidation. References Benartzi, S., Thaler, R H (2001) Naïve diversification strategies in retirement savings plans. American Economic Review 91-1, 79–98. Davis, S R (2002) Portfolio Design. Evanson Asset Management —. Retire Early and Sleep Well. New York: Grote Publishing Ernst, J. Bamford and D. (2002) Managing an Alliance Portfolio McKinsey Quartely Volume 3, pages 28-39, Stuart Flack. Foust, Dean. (2009) "Portfolio Planning: A Case Study." 2 July 2009. BusinessWeek. [Accessed on 3 September 2009] from . Jacobs, Peter H. M. (2003) An Architecture for Decision Support on Portfolio Design. 16th Bled eCommerce Conference eTransformation. Bled, Slovenia,: Delft University of Techology, The Netherlands, pg. 59-65. Jeffrey R B, N Liang, & S Weisbenner (2007) Individual account investment options and portfolio choice: Behavioral lessons from 401(k) plans. Journal of Public Economics 91 : 1992–2013. Kelly, J. April J & F. Glover (2002) . Portfolio Optimization for Capital Investment Projects WinterSim conference. USA, 2002. Markowitz, H. (1952b) Portfolio Selection. The Journal of Finance, Volume VII, No.1: 77-91. Markowitz, H. (1959b), Portfolio Selection: Efficient Diversification of Investments, John Wiley, New York McVean, J.R. (2000) The Significance of Risk Definition on Portfolio Selection. SPE annual technical conference and exhibition. USA Sherin. (2009) Portfolio Balance Model - A Case Study. MoneyHacker.com. [Retrived from 3 September 2009] . Singla, H. K. (2006). A paper on- Long Standing Puzzle in The Capital Asset Pricing Model. Jaipur: Maharishi Arvind Institute of Science & Management. Appendix Figure 2 The Market Security Line, illustrates the co- relation of the beta and the asset's projected Rate of Return Figure 3 Figure 4 The American Association of Individual Investors Return (AAIIR) Data as of 31/7/2009 Investment Benchmarks 1 yr 5 yrs 10 yrs Large-Cap Stocks -19.91% -0.22% -1.26% Mid-Cap Stocks -20.43% 2.66% 5.25% Small-Cap Stocks -19.33% 2.27% 4.20% International Stocks -22.89% 4.74% 1.32% Emerging Markets Stocks -16.55% 16.96% 10.62% Intermediate Bonds 6.86% 5.66% 6.64% Short-Term Bonds 4.68% 4.33% 4.99%   Asset Allocation Returns 1 yr 5 yrs 10 yrs Aggressive Portfolio -17.50% 4.20% 3.60% Moderate Portfolio -12.20% 4.00% 3.90% Conservative Portfolio -6.90% 3.40% 3.90% Figure 4 Read More