Topic: Case Study – Managing Individual Investor Portfolio Management Unit – 2 Session No.18 Topic: Case Study – Managing Individual Investor

Case Robert Taylor, 50 years old and a U.S. resident. Recently retired and received a $500,000 cash payment from his employer as an early retirement incentive. Also obtained $700,000 by exercising his company stock options. Both are taxable. Taylor is not entitled to a pension; His medical expenses are covered by insurance paid for by his former employer. Taylor is in excellent health and has a normal life expectancy

Case Taylor’s wife died last year after a long illness. All their investments, including a home, were liquidated to fully satisfy these medical expenses. Taylor has no assets other than the $1.2 million cash referenced above, and he has no debts. He plans to acquire a $300,000 home in three months After settling into his new home, Taylor’s living expenses will be $2,000 per month and will rise with inflation. He does not plan to work again.

Case Taylor’s father and his wife’s parents died years ago. His mother, Renee, is 72 years old and in excellent physical health. Her mental health, however, is deteriorating (declining) and she has relocated to a long-term-care facility. Renee’s expenses total $3,500 per month. Her monthly income is $1,500 from pensions. Her income and expenses will rise with inflation. She has no investments or assets of value. Taylor, who has no relations, must cover Renee’s income shortfall.

Case

Case Taylor has one child, Troy. Troy and a friend need funds immediately for a start-up business with first-year costs estimated at $200,000. The partners have no assets and have been unable to obtain outside financing. The friend’s family has offered to invest $100,000. Taylor agrees to invest the same amount He plans to make a decision on this investment If he invests, he insists that this investment be excluded from any investment strategy developed for his remaining funds.

Case Question - A: Evaluate the appropriateness of Taylor’s investment policy statement with regard to the following objectives: i. Return requirement ii. Risk tolerance iii. Time horizon iv. Liquidity requirements

Case Answers: i. Return requirement The IPS’s return objective section is inadequate Taylor’s personal income requirement has not recognized the need to support Renee. Wheeler does not indicate the need to protect Taylor’s purchasing power by increasing income by at least the rate of inflation over time. Wheeler does not indicate the impact of income taxes on the return requirement.

Case Wheeler calculates required return based on assets of $900,000, appropriately excluding Taylor’s imminent $300,000 liquidity need (house purchase) from investable funds. However, Taylor may invest $100,000 in his son’s business. If he does, Taylor insists this asset be excluded from his plan. In that eventuality, Taylor’s asset base for purposes of Wheeler’s analysis would be $800,000. Assuming a $900,000 capital base, Wheeler’s total return estimate of 2.7 percent is lower than the actual required after-tax real return of 5.3 percent ($48,000/$900,000) - $2000 required for him and $2000 require for his mothers shortfall.

Case The risk tolerance section is inappropriate. Wheeler fails to consider Taylor’s below-average willingness to assume risk as exemplified by his aversion to loss, his consistent preference for conservative investments, his adverse experience with creditors, and his desire not to work again. Wheeler fails to consider Taylor’s below-average ability to assume risk, which is based on his recent life changes, the size of his capital base, high personal expenses versus income, and expenses related to his mother’s care. Wheeler’s policy statement implies that Taylor has a greater willingness and ability to accept volatility (higher risk tolerance) than is actually the case. Based on Taylor’s need for an after-tax return of 5.3 percent, a balanced approach with both a fixed-income and growth component is more appropriate than an aggressive growth strategy.

Case The time horizon section is partially appropriate. Wheeler accurately addresses the long-term time horizon based only on Taylor’s age and life expectancy. Wheeler fails to consider that Taylor’s investment time horizon is multistage. Stage 1 represents Renee’s life expectancy, during which time Taylor will supplement her income. Stage 2 begins at Renee’s death, concluding Taylor’s need to supplement her income, and ends with Taylor’s death. The liquidity section is partially appropriate. Wheeler addresses potential liquidity events. Wheeler fails to specifically consider ongoing expenses ($2,000/month for Taylor’s living expenses and $2,000/month to support his mother) relative to expected portfolio returns. The reference to a ‘‘normal, ongoing cash reserve’’ is vague. The reserve’s purpose and size should be specified.

Case

Case Question – B:. Select the strategic asset allocation that is most appropriate for Taylor and justify your selection with two supporting reasons related to the revised information shown above. Allocation B is most appropriate for Taylor. Taylor’s nominal annual return requirement is 6.3 percent, based on his cash flow (income) needs ($50,400 annually), to be generated from a current asset base of $800,000. After adjusting for expected annual inflation of 1.0 percent, the real return requirement becomes 7.3 percent. To grow to $808,000 ($800,000 × 1.01), the portfolio must generate $58,400 ($50,400 + $8,000) in the first year ($58,400/$800,000 = 7.3%). Allocation B meets Taylor’s minimum return requirement. Allocation B also has the lowest standard deviation of returns (i.e., the least volatility risk) and by far the best Sharpe ratio. Allocation B offers a balance of high current income and stability with moderate growth prospects.

Case Allocation A has the lowest standard deviation and best Sharpe ratio but does not meet the minimum return requirement when inflation is included in that requirement. Allocation A also has very low growth prospects. Allocation C meets the minimum return requirement and has moderate growth prospects but has a higher risk level (standard deviation) and a lower Sharpe ratio, as well as less potential for stability, than Allocation B.