Calculating return required

In the first exam of the Schweser 2013 practise exams, first exam, question 1 it asks to calculate the return required.

In the answers, they don’t take the first year of expenses out of the portfolio sum before calculating the return required.

It would seem to me that you need to hold that amount as cash in your portfolio, and would calculate the return required on what is left and what is investable in the portfolio.

Any commentary would be appreciated. Usually when I’m wrong, I can find where the explanation is coming from but on this one I still disagree.

Also, in the next part of the question, Q2. It asks how much cash the portfolio should hold. The portfolio needs more than 5% cash to pay for expenses in the first year, but the ‘correct’ answer is holding 0-5% cash. (need 5.02%)

Does anybody find this kind of thing often? They’re not really major problems but am wondering what anybody has to say about it, I HATE discrepencies between what I’m doing and the answer book!

I just took the exam. I didn’t even attempt the return calculation. I mean there’s no fun in putting these question vaguely and testing candidates. It’s really dumb.

But I’m just saying because I managed on 56% in the am.

Pm was still ok and I managed 73%. Sorry that I don’t have answer to your question.

I wanted to know why did they consider the gift as tax free in question 6 - in the relative value formula. Shouldn’t 30% tax be used in the formula?

And did you find the exam difficult?

Did you mean in question 7? I didn’t get a hold of any of question 7, I thought they were talking about the benefits of gifting the entire inheritance straightaway (2 mil apiece) which was why they pointed out core capital and excess capital.

Big swing and a miss! BUT the 15,000 gift was tax free because a gift under 15,000 is tax-free (that information is in the question but I’m not sure why it was only 15,000 it doesn’t seem clear to me even after knowing that).

Well this is the second AM exam I’ve done, I’ve found that some things I need to elaborate on a bit more. All in all I found this one a lot better than the last one I did but I’m not sure how I’d go hazarding a guess at an actual mark. The last one I did was a slaughter though, I think after doing a LOT of questions this month, I should be able to see what information they are looking for in the AM questions, similar to what it was like getting used to all the questions originally.

I guess even though you might be comfortable knowing the information, applying it in the way that the CFA wants you to is a part of the testing process for yourself, before exam day and on exam day to make sure you’re thinking the way they want you to.

I haven’t done the PM yet but I’d be pretty happy with a 73%!

Not that I agree with the following philosophy, but I think this is what CFAI expects:

Reserve cash only for one-time sure expenses like a surgery in 3 months. Otherwise go ahead and exhibit overconfidence bias and assume that the portfolio will actually realize the expected return using the total return metric (i.e. not just cash from dividends and income but also capital gains).

Also remember to take out PV of anything they give, e.g. if PV college expenses is $100,000 and the client has a strong desire to pay for college, just subtract $100,000 from the portfolio right away.

Cheers for the reply, so you think that CFAI expect you to take one-time expenses out of the portfolio amount, but do NOT take out living expenses for the year? (that is what the answer book is telling me to do)

That just doesn’t make any sense to me, you can’t invest your living expenses the year that you need them?? Or do we assume that the investment provides enough yield, at the right times to pay for expenses? It’s a pretty flawed assumption IMO so I wouldn’t mind a clarification… Do you agree with the statement, ‘do NOT subtract yearly expenses from the value of the portfolio until AFTER the year has finished’?

I don’t know what your last statement means, exactly.

The portfolio WILL earn first year’s expenses and keep its real value, i.e. also earn more to cover inflation.

If the portfolio is $1M and first year’s expenses are $40K and inflation is 3%, it WILL earn 7% and in real terms, equal $1M (or in nominal terms, $1,030,000) at the end of the year.

Do not start with a portfolio of $960K by subtracting $40K at the beginning of the year.

Common sense does not enter into this equation until after the exam.

Haha yeah that is cleared up cheers. I wanted to start with a portfolio of 960k.