Question

You are currently planning an investment strategy designed to partially finance your eight-year-old child's education. You have $10,000 to invest and your child will begin university studies ten years from now. Your financial advisor recommends that you buy some Telstra shares. Telstra shares have a beta of 0.9 and the returns on Telstra shares have a standard deviation of 40% p.a. The riskless rate of interest is 5% p.a. and the market risk premium is 7% p.a. The standard deviation of the return on the market is 20% p.a.

If you follow the advice of your financial advisor, how much do you expect to have available when

your child begins university?

You become aware that your bank is marketing an Australian Equities Index Fund. The goal of this fund is to exactly match the performance of the All Ordinaries Index (a broad stock market index). If you invest in this fund, rather than the Telstra shares, how much do you expect to have available when your child enters university?

Finally, a colleague suggests that you shouldn't limit yourself to choosing between investing everything in Telstra or everything in the index fund. He suggests that you can do even better by diversifying. In particular, he suggests an equally-weighted portfolio consisting of $5,000 invested in Telstra shares and $5,000 invested in the index fund. What do you think about your colleague's advice?

Answer 1

Amount available by child begins university if invested in Telstra stocks

Years for child starting university	10
Amount to be invested	10,000.00
Telstra Beta	0.9
Telstra Standard Deviation	40%
Riskless rate	5%
Market risk premium	7%
Market return (Market risk premium + Riskless rate)	12%
Market Standard Deviation	20%
Annual Expected return on Telstra ==> Risk free rate + Telstra Beta x (Market risk premium)	5%+0.9*7%
Annual Expected return on Telstra ==> Risk free rate + Telstra Beta x (Market risk premium)	11.30%
Future value factor ==> (1+ annual expected rate)^no. of years	2.9171
Amount available by the time Child starts university if invested in Teelstra==> Amount to be invested x Future value factor	29,171.02

Amount available by child begins university if invested in index fund ( assuming market return would depict the return from index fund which woud be a combination of prominent equities in the market)

Amount to be invested	10000
Market return (Market risk premium + Riskless rate)	12%
Future value factor ==> (1+ market return)^no. of years	3.1058
Amount available by the time Child starts university if invested in index fund ==> Amount to be invested x Future value factor	31,058.48

Amount available by child begins university if invested in a portfolio of index fund and Telstra stock

Total Amount to be invested	10,000.00
Amount to be invested in index fund	5,000.00
Weight of market index (investment in index fund / Total investment)	50%
Return of market index	12%
Amount to be invested in Telstra	5,000.00
Weight of Telstra stock (investment in Telstra/ Total investment)	50%
Return on Telstra stock	11.30%
Expected return from diversifying (investment in Telstra and index fund)	11.65%
Future value factor ==> (1+ expected return from diversifying)^no. of years	3.0101
Amount available by the time Child starts university investment is diversified into market index and Telstra stock==> Amount to be invested x Future value factor	30,101.44

Hope this help you answering the question. Please provide your feedback and rating to the answer.

Thanks