Reading 14: Managing Individual Investor Portfolios －LOS m package, black, white, style

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Q2. Bill Kelley, age 55, just retired and accepted an early retirement package from his employer, FertileGro Lawncare. The early retirement package has an estimated value of $1.2 million after taxes. After taking the retirement package, Kelley took a job in customer service at a local hospital and currently has a salary of $50,000 per year. Sharon Kelley, age 54, works part-time as the Treasurer for their church and has a salary of $15,000 per year. They have two children, Shannon, age 31, and Sarah, age 18. Shannon is married and does not require financial assistance, while Sarah is in her first year of college. The Kelleys consider the early-retirement package a wonderful addition to their existing $2 million in savings. They have no debt and pay their expenses on monthly basis. Total family expenses last year amounted to approximately $93,750.

Bill and Sharon Kelley recently approached Modern Portfolio Management, Inc. for help in managing their portfolio. At a recent fact-finding meeting, the Kelleys made the following statements:

• Our primary goal is to pay for the college education of our youngest daughter, Sarah. Tuition, room, and board last year was $30,000 and is expected to grow at 5% per year.

• We want to retire at age 65 and live comfortably.

• We are taxed at a 25% rate on dividends, capital gains, and income.

• Inflation is expected to grow at 2.5% per year indefinitely.

• People get too excited about the stock market - they talk about making all of this money, but they could turn around and lose it tomorrow. We don’t want to be in any individual investment or security that is considered too risky.

• We do not foresee any unusual expenses, but like to keep some cash on hand, just in case of emergencies.

Modern Portfolio Management presents the Kelleys with four model portfolios. Which of the portfolios would be best suited for the Kelley’s situation?

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A)   Portfolio 1.

B)   Portfolio 2.

C)   Portfolio 3.

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答案和详解如下：

Correct answer is B)

Portfolio 2 is the optimal portfolio. The Kelley’s have at least a 2 stage time horizon.

The inflows are $50,000 + $15,000 = $65,000 before tax = $65,000 (1-.25) = $48,750 after tax.

The outflows have to be adjusted for inflation since they were last year's costs thus we have:

§   $93,750 total costs last year = $30,000 tuition + $63,750 living expenses

§   Tuition expenses adjusted for inflation are $30,000 × 1.05 = $31,500

§   Living expenses adjusted for inflation are $63,750 × 1.025 = $65,344

§   Total outflows in the first year of retirment = $31,500 + $65,344 = $96,844

Inflows - outflows = $48,750 - $96,844 = -$48,094

Required return = 48,094 / 3,200,000 = 1.5% after tax real required return

Adjusting for inflation = 1.5 + 2.5 = 4.0% after tax nominal required return

4.0 / (1-.25) = 5.33% before tax nominal required return

Portfolio 2 meets the return requirement and also is in line with their low risk tolerance as indicated by not wanting to be in a security that is too risky. Portfolio 3 is also not acceptable because it is not well diversified and has 20% allocated to cash. Portfolio 1 looks like a good choice, especially with its slightly higher return than Portfolio 2 and broad diversification, however the portfolio has a much higher than necessary cash allocation, and the lack of return from cash seems to be made up for by a 10% stake in venture capital. Portfolio 2 appears to be a better match with the Kelley’s risk tolerance.

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