page 184, book 2, top paragraph; CFAR what is the 5%? is it real or a nominal return?? 4%=inflation 7%=real req’d return + inflation (i.e. 3+4) Expenses = $500,000 x (1.04)^7 = $658,000 and Portfolio Value = $2,000,000 x (1.07)^7 and + $10,000,000 = $13,211,500 $658,000/$13,211,500 = 5% is this a real return? I don’t know? I think we’ve included/adjusted for inflation in both the expenses and the portfolio (albeit, not entirely) so what is the “5%” doesn’t it equal a Nominal Required Return? thanks a
I was just about to post on this and I saw yours. Personally I think this whole Reading is really weak. 1. If you run it out beyond year 7 on a spreadsheet, you’ll see that the 5% “required return” is only sufficient if the $657,000 never grows again. With inflationary increases the required return has to grow in years 8, 9, 10… 2. Where did the 10.8% come from? Yes, I know, it’s the tax adjusted nominal rate of return. But this rate of return is Susan’s “acceptable” return – it has no relationship (not even expectational) to what will actually happen during those first seven years. In effect, CFAI has arbitrarily set return for years 0-7 and concluded (as a byproduct of this assumption) that she needs 5% in years 8 through forever. 3. On that last note why is it forever? In the case of an endowment, or someone who says “I want to preserve my principal for my kids or for charity.” But when the person doesn’t say that, why is there an automatic presumption that principal must be preserved? In Susan Fairfax’s case, she could meet her living expenses at a lower rate than 5% if she dipped into her principal. This isn’t even considered, although she has no family and no obvious beneficiaries or even charities.
-TO4T- I agree with what you said…To expand even further…(on a minor scale) I would like to know why they give us the real required return = 3% then talk about the tax adjusted nominal rate of return using that same 3% (real rate of return). They then show us a how to calculate the “return” of 5%, and don’t bother comenting on it or whether we need to “back out” in the same fashion to calculate the nominal rate of return?? Which I don’t think we should because it has “factored” in inflation?
Almo, After thinking about this for a while I cannot find an explanation for an apparent mixing of after tax and pretax values. I think they should have multiplied the 2,000,000 by 1.108^7, instead of 1.07^7, which should generate 4,100,231. Adding the 10 million of pretax stock value, this would be 14,100,231 of pretax portfolio value at the end of 7 years. To calculate pretax return I divide pretax 658,000 by pretax 14,100,231=4.67% Would anybody else agree that the 5% return calculated in the CFAI example is not correct?