Emma Young, a 47-year-old single mother of two daughters, ages 7 and 10, recently sold a business for $5.5 million net of taxes and put the proceeds into a money market account. Her other assets include a tax-deferred retirement account worth $3.0 million, a $500,000 after-tax account designated for her daughters’ education, a $400,000 after-tax account for unexpected needs, and her home, which she owns outright.

Her living expenses are fully covered by her job. Young wants to retire in 15 years and to fund her retirement from existing assets. An orphan at eight who experienced childhood financial hardships, she places a high priority on retirement security and wants to avoid losing money in any of her three accounts.

A broker proposes to Young three portfolios, shown in Exhibit 1. The broker also provides Young with asset class estimated returns and portfolio standard deviations in Exhibit 2 and Exhibit 3, respectively. The broker notes that there is a $500,000 minimum investment requirement for alternative assets. Finally, because the funds in the money market account are readily investible, the broker suggests using that account only for this initial investment round.

Exhibit 1

Proposed Portfolios

Asset Class |
Portfolio 1 |
Portfolio 2 |
Portfolio 3 |
||
---|---|---|---|---|---|

Municipal Bonds | 5% | 35% | 30% | ||

Small-Cap Equities | 50% | 10% | 35% | ||

Large-Cap Equities | 35% | 50% | 35% | ||

Private Equity | 10% | 5% | 0% | ||

Total | 100% | 100% | 100% |

Exhibit 2

Asset Class Pre-Tax Returns

Asset Class |
Pre-Tax Return |
---|---|

Municipal Bonds | 3% |

Small-Cap Equities | 12% |

Large-Cap Equities | 10% |

Private Equity | 25% |

Exhibit 3

Portfolio Standard Deviations

Proposed Portfolio |
Post-Tax Standard Deviation |
---|---|

Portfolio 1 | 28.2% |

Portfolio 2 | 16.3% |

Portfolio 3 | 15.5% |

Young wants to earn at least 6.0% after tax per year, without taking on additional incremental risk. Young’s capital gains and overall tax rate is 25%.

According to CFAI, the right answer is portfolio 3. Portfolio 1, 2 and 3 have after-tax returns of 9.15%, 6.64% and 6.68% respectively. When you analyze risk-adjusted return using Roy Safety first ratio (Er-MAR/st deviation): for Portfolio 1, 2 and 3 you get 11%, 4% and 4% respectively which makes portfolio 1 the most efficient to me. Further, Portfolio 1 meets the minimum alternative investment (PE allocation of 10%). Can someone explain why portfolio 3 is still the right answer? Thanks!