Question

You just celebrated your mom’s joint 65th birthday and retirement partly. Mom has been living on her own for several years. She currently has $573,000 saved. The savings are split between a traditional bricks and mortar bank savings account earning 0.1%, and an on line savings account earning 0.8%. Mom will immediately begin receiving $800 per month from social security. Over the past three years mom’s average pre tax income has been $41,750. Your mom is a committed member of First Presbyterian and faithfully tithes 10% of her after tax earnings. Mom has invited you to help her write down a plan for her retirement years. Mom’s parents both lived to 85. Follow the steps of a basic ‘Portfolio Management Process’ and write mom a two-page letter with your recommendations of what she do.

Answer 1

The Portfolio Management Process is the process which the investor must follow to meet his or her financial goals in the future. The steps that should be followed in the process to achieve the financial goals are:

PLANNING

1) First an Investment policy statement, IPS is created that contains the investor's financial goals and the constraints. The investor’s financial goals would require particular return to be achieved and there is accompanied investment risks, the risks that investor demands could be lower or higher depending on the various factors. Mom has higher age and has full retirement to live off therefore she would require a lower to moderate level of risk and return. The returns should be just sufficient to meet her retirement needs without taking too much risk. She has $ 800 from the social security that should not be enough to meet her monthly needs during retirement so she requires additional steady incomes that could be fulfilled by a lower return and moderate risk portfolio given that she has large savings of $573,000. Seeing that there is source of earning from the social security and that she has a large amount of savings therefore the portfolio risk required is not too high and that she requires adequate money to meet her retirement need she requires a lower return. Therefore, a portfolio earning lower return with a moderate risk is most appropriate for her.

Mom has $573,000 which can be invested in the portfolio of Asset classes as chosen by the return maximization technique of portfolio optimization. Her earnings has been 41750 and that she shall receive 800 per month or 9600 per year form the social security therefore she would require 41750-9600 or 32150 per year for 20 years till she is 85 from the portfolio as returns to meet her living expenses when the effects of inflation are ignored. Let the rate of return required form the portfolio be r. The value of portfolio today of $573,000 equals the present value of the cash flow of 32150 per year for 20 years she requires with these cash flows discounted at rate of return r.

Therefore, the Mom's required rate of return for retirement from the portfolio is just 1.124 %.

2) Second is developing an Investment strategy based on capital market expectations that is forecasting the expected returns and risks of various asset classes in the future and minimizing the risk for a given return of 1.124 % for the portfolio of these asset classes.

3) Thirdly is strategy Asset allocation where the weights in the Assets classes are found by combining capitals market expectations and the investor's needs .The return for mom of 1.12 % could be set as goal that is achieved by combining the Asset classes in proportions which results in the given return by minimizing the risk. Under tactical asset allocation the portfolio weights can be tilted to meet the investor's changing needs and the changing market condition on time to time basis.

EXECUTION

In the Execution stage the portfolio is selected and executed by doing transaction in various asset classes that constitute the finalized portfolio. Transactions costs as taxes, fees, commissions can reduce the return for the portfolio hence the costs needs to be managed and should be timely.

FEEDBACK

1) In this stage the portfolio manager evaluates and monitors the portfolio and compares it with the desired strategic allocation and makes sure that the desired return and risk objectives are being met. Manager should balance portfolio as and when reordered based on changing market conditions so as to ensure that the objectives are achieved.

2) Portfolio should be evaluated frequently to assess the performance of the portfolio manager and the achievement of the objectives.