Question

Ayasha, age 30, is beginning to contemplate her financial future. Right now, she lives in a large city where she rents a one-bedroom apartment. Although she loves the excitement of the city, she knows that someday she would like to move to the country and live in a farmhouse. Her goal is to begin saving for this objective right away. Ayasha has identified three possible portfolios that might be appropriate choices as she begins investing to reach her objective. Each portfolio consists of the following stocks, bonds, and cash assets.

Portfolio 1	Portfolio 2	Portfolio 3
10% cash	10% cash	15% cash
20% bonds	40% bonds	50% bonds
70% stocks	50% stocks	35% stocks

Instructions:

1. Calculate the weighted average rate of return for each portfolio, assuming that the average return of each asset is as follows. (Hint: Multiply the allocation percentage by the rate of return to determine the “weighted average” for the asset: stocks 9%, bonds 4%, and cash assets 2%.)

   

2. Which portfolio has the greatest level of uncertainty associated with the returns? How can you tell?

3. If Ayashaʼs risk tolerance is below average and she has a long-time horizon (15 years), which of the three portfolios would be most appropriate for her?

4. If Ayashaʼs time horizon for goal achievement is 4 years, which portfolio would be most appropriate?

5. What type of risk does Ayasha face if she invests in portfolio 3?

Answer 1

A.

Weighted average return on portfolio refers to the return on the assets in the portfolio on the basis of assets comprised in the portfolio. In other words, it is computed by multiplying the return from the assets with the weightage of investment in such asset.

Following is the formula table for computation of weighted average return:

Following is the computation of weighted average return:

Thus the weighted average return for each of the portfolio has been computed as above.

B.

In the financial markets, the most volatile financial instrument is stock which fluctuates very dynamically in relation to the market. Systematic as well as unsystematic risk have a very drastic effect on a stock and thus investment in such instrument causes more threat to the investor.

Hence, in case of portfolio 1, where 70% allocation has been made to the stock which shall cause the investor likely to be associated with highest level of uncertainity and vulnerable with market fluctuations.

C.

In such a case, portfolio 2 would be most appropriate because in such a long run time, the market would get balanced as per the trend in the economy. Also, there is 40% investments in bonds which will balance portfolio returns fromt their coupon payments. Portfolio 1 could not be recommended because her risk is below average therefore, it is recommend to invest in portfolio 2.

D.

If the time horizon is 4 years with below average risk, then the most appropriate portfolio for investment is Portfolio 3. Such investment should be made as there is less investment in stock which shows that investor's portfolio will get balanced with volatile returns. Also there is more investment in bonds so that investor will be protected from high fluctuations in the market.

E.

Ayasha will face credit risk as well as interest rate risk if she invests in Portfolio 3 as half of the amount has been invested in the bonds.

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