Investment Concepts Course Paper

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Investment Concepts Course Paper

• Course Paper Entitled
• Asset Allocation Analysis

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Purpose of the PaperTo deepen each students
understanding of the issues involved in the
asset allocation decision
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Procedure

• Become familiar with the Investment Scenario
• Decide what asset classes you might wish to
  consider
• Develop asset allocation input estimates using
  past data, current market conditions, and your
  judgement
• Run Asset Allocation (do not allow short-sales,
  specify desired min/max percentages for each
  asset class)
• Examine percentile distributions of terminal
  wealth and annualized returns for various
  investment horizons.
• Examine shortfall risk as the investment horizon
  lengthens
• Create a new percentile distribution called
  Percentile Distribution of After-Tax Annuity
  Income
• Evaluate various Asset Allocation Strategies that
  the investor might consider between now and
  during retirement
• Write the paper.

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Scenario

• You have just been employed by HS Group, an
  information technology consulting firm. In
  talking with Jack Buck, a manager at the firm,
  the topic of retirement investing came up.
• Jack and his wife, Jill, are both professionals
  aged 35. The have two children in elementary
  school. They are financially stable and have
  sufficient insurance to protect them against
  unforeseen personal emergencies. They both intend
  to work until retirement in their mid-60s.
• Jack and Jill presently have about 100,000
  invested in a retirement savings plan. In
  speaking with Jack, he says
• You know, I really dont know whether this
  100,000 is properly
• invested. In addition, I have no idea of what the
  portfolio might be
• worth when I retire nor what yearly after-tax
  annuity
• might be possible with the funds available then.
• You, of course, get very excited and see this as
  an opportunity to play with the ideas discussed
  in your Investment Concepts course back in the
  MBA program.

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Scenario Caveat

• You are to examine only the potential future
  worth of the 100,000, even though Jack and Jill
  will certainly make additional contributions to
  their retirement fund.
• The reason why you will not examine the potential
  future value of all cash contributions is that
  the only way to do so is via a computer
  simulation. Writing such a simulation is beyond
  the scope of this class.

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Asset Classes

• Keep them standard
• Money Market funds (Tbills)
• Domestic Bonds (long-term treasuries or l-t
  corporates, not both)
• Domestic Large Cap Equity (SP 500 or Russell
  1000)
• Domestic Small Cap Equity (DFA9-10 or Russell
  2000)
• Developed Non-U.S. Countries (EAFE)
• Clear any other asset classes that you might wish
  to include with the instructor first (to keep you
  from running into problems)

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Input Assumptions

• The Terminal Wealth calculations in Asset
  Allocation are based on continuous compound
  returns. Be sure the Efficient Frontier input
  data is also expressed as continuous returns.
• Lets base everything on real (after subtracting
  inflation) annual returns.
• You may choose the historical time period
  (1926-1998, only post WWII, - just be sure it is
  long enough to give a reasonable sample of past
  asset class returns)
• Be sure your input assumptions are consistent
  with current market conditions (make expected
  real bond return about equal to current long-term
  bond YTMs after expected inflation)

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Asset Allocation

• The computer package that calculates the
  efficient frontier, percentile distributions of
  terminal wealth, geometric means, etc. is
  available on the class web site. It is called
  Asset Allocation. Be sure to obtain the
  associated manual.
• If you have any problems, please contact Dr
  Radcliffe.
• The only problem noted in the past is
  singularity, data for one asset class is some
  linear combination of data for the other classes.
  If you hit this problem, change the value of some
  inputs by a small amount and rerun the program.

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Calculate Percentile Distributions of Terminal
Wealth and Annualized Returns

• Asset Allocation automatically calculates
  terminal wealth and geometric return percentile
  distributions.
• Be sure to examine these and discuss tem in your
  paper.

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Percentile Distributions ofAfter-Tax Annuity
Income

• Assume
• all withdrawals from the portfolio (they all will
  occur during retirement) will be taxed at a 30
  rate
• once they reach retirement, they will invest the
  full portfolio value into securities that will
  (assume no uncertainty) provide a real Discrete
  pre-tax rate of return equal to 3 per year.
• Annuity withdrawals will be made at the end of
  each year (the 1st occurs one-year after
  retirement (this means we use a regular annuity
  factor - keeps the math simpler)
• the life of the annuity will be the difference
  between their age when you assume they retire and
  age 90

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Percentile Distribution ofAfter-tax annuity
income to pre-retirement income

• This is not noted on the Procedures page. But
  you might find it interesting.
• First, calculate the couples after-tax income at
  the date they retire.
• Current after-tax income for the couple is
  70,000
• Yearly real (we are doing everything
  pre-inflation) compound growth in this will be 3
  per year (with certainty, also consider the 3 to
  be a discrete interest rate not continuous -
  easier math)
• Next, for each percentile annuity value,
  calculate the fraction that this annuity
  represents of their after-tax income at
  retirement.
• People can relate to a number such as this better
  than they can some future after-tax annuity
  income.

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Asset Allocation Strategies

• The previous analysis was based on a static asset
  allocation, what would happen if they maintained
  a fixed asset allocation until retirement.
• In most cases people should and will, reduce
  their portfolio risk as they approach retirement.
• The previous analysis assumed the couple switched
  asset allocation at one date only. This was at
  retirement when they went from a (probably) risky
  allocation to a risk-free allocation.
• In this part of your analysis you should point
  out the fact that asset allocation should depend
  on their investment horizon and discuss why.
• No numbers are required (please do not calculate
  any - better ways to spend your time).
• But you might wish to say that a zero risk
  position when they enter retirement is debatable
  if they have 20-30 years of life ahead.

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Write the paper

• Title Asset Allocation Analysis
• Organization is up to you
• Include useful tables and graphs (no extraneous
  stuff to bulk it up)
• There is no page requirement or page limit.
  Simply do what you need to do satisfy yourself.
• Many sub-headings please!!!!!
• The purpose of this paper is to improve your
  understanding of asset allocation. Use it to do
  so. But also work on the presentation of a well
  worded and professional looking paper, something
  of which you can be proud.