Question

Case Study on Managing an Investment Portfolio

As a recently hired CFA financial analyst for Horizon Investments you have been asked to make portfolio recommendation and setup an investment policy statement for three clients of the firm.

1) John Lambert has recently received his MBA and currently works for Oracle. He is 26 and recently married. He and hid wife have saved nearly $100,000 for a down payment on a home. He contributes 10% of his salary to a 401K and Oracle provides a 10% match.   The investments are made in mutual funds run by Fidelity Investment. The 401K offered by Oracle has access to all of the funds offered by Fidelity. John Lambert needs to have a detailed investment plan set up for his 401K including the name of the funds and percentage of portfolio to be invested in the funds.

2) Elizabeth Yeo, aged 60, is managing director of USX and plans to retire in one year. Yeo will receive a lump sum severance payment of $500,000 from the company and plans to close out her company 401K which is entirely invested in USX stock where she has currently about 35,00 shares. Yeo is widowed and has a son who is married and who has a high-level position at an investment bank. Yeo maintains a money market fund currently value at $1.1 million and earns about 1.2% annually. She has a home, zero mortgage, currently valued at about $1 million and plans to continue living there. She also plans to begin to collect social security at the age of 62. Her living expenses, including maintaining the home, are about $80,000 a year. Her living expenses are expected to grow at an annual rate of 3 percent throughout her retirement period, which is expected to be 25 years given her family’s mortality history. You are requested to prepare an investment policy statement for Yeo and make some investment recommendations.    

3) Christopher Maclin, aged 40 is a supervisor at Barnett Co. and earns an annual salary of $100,000. Louise Maclin, aged 38, stays home to care for their newborn twins. She recently inherited $1.3 million (after taxes) in cash from her father’s estate. In addition, the Maclins have $20,000 in cash and $150,000 in Barnett common stock. They are unhappy about portfolio volatility and do not want to suffer a loss of more than 12% in one year. They recently purchased a new home. They need sufficient funds to fund their children’s college education and Christopher plans to retirement at age 65. Christopher is not very knowledgeable about finance but read that small cap and emerging market stocks provide the highest return over the long run. He plans to invest 50% of the inherited money in a small cap fund and the other in an emerging market fund. His wife is concerned about the decision. She requested Horizon review her husband’s decision and, if needed, provide an alternative investment strategy.

Answer 1

1. Since John and his wife are young, they have the age on their side and can go through various investment lifecycles and take larger risks to recover.

They have also saved for down payment of their house and thus will rely on salary for mortgage payments.

They can certainly allocate significant percentage to risky equity portfolio (>60%), 20% to large cap equity investments and remaining in GSec funds.

2. Elizabeth has a comfortable cash flow at the moment with investment in money market funds. Given that there is no information on whether she needs to prepare for her children/grand children, we can assume all the assets and cash will be utilized by her for her well being and medical expenses.

Her money market funds are providing her substantial cash flows for the yearly expenses.

Remaining funds including her cash, 401K proceeds can be additionally invested inflation indexed bonds with highest credit rating to provide her additional steady income.

Additionally she can go for a reverse mortgage on her house to realize the equity value of her house over a period of time which can be invested in G-Secs to realize the safe payments every year.

3.Christopher is middle aged and has clear goals:

1. They need to have adequate funds for their children education, say in 18-20 years and thus they need to define a corpus which can grow at a consistent rate to provide for their children education.

2. Retirement funds to be accumulated 25 years from now.

3. Mortgage payments will be made from the salary (assuming house is on mortgage or otherwise this is additional asset)

4. They do not like stock volatility.

Thus, we need to advise christopher:

a. Small cap and emerging market stocks have higher returns but will have high volatility and is thus not for their liking.

b. They can invest a corpus of funds (50% - assume children education will cost atleast 100,000$ each in 20 years) in AAA rated municipal bonds to get adequate funds for their children education

c. A portion of their funds 20%-30% can be invested in equity (large cap funds) to get a consistent risk adjusted growth

d. Remaining funds can be invested in high risk equity funds for upside

e. Newly purchased home can be utilized for the reverse mortgage and retirement funds in addition to the equity funds growth above. The portfolio needs to be managed over a period of time with age with funds being transferred to low risk instruments after 10 years and then even lesser risky funds after 10 years, and then inflation indexed bonds as mentioned above in pt.2