schweser always does it. When calculating next year’s return, they first multiply last year expenses by (1+inflation), then at the end they add the inflation again. How does that make sense?
does anybody have an answer to this question?
It confused me too at first. It’s because they calculate NEXT year return, not this year return. It makes sense - Just look at it as next year spending requirement 1) At t=1 your expense will grow with inflation, so you will need to spend $amount = last year expense *(1+i), and when you take it out at t=1 your remaining value = value at t=0 2) To grow that value in real terms you need to multiply by (1=i) again (or just add i) Does it makes sense?
if I force myself for a sense it will make sense. it all comes down to wording and interpretation. just stupid stuff. it’s wrong either way anyway, u dont make your expenses as a lump sum at one single point in time!
Come on the above is a good explanation. If I say I need 200,000 now from 2,000,000. You will just calculate the percent easily. You need to make this calculation for next year and inflation is given, lets say 2%. you know your spending will grow by this amount. Calculate percent using this inflated number. Then you also know that you want to protect the purchasing power of your remaining portfolio, so it has to grow at least in proportion to inflation after your spending requirement is satisfied. To see how correct it is, grow portfolio by spending rate+inflation. take out your spending, left over portfolio will be larger than the initial portfolio by the amount of inflation.
I agree, but they ask to calculate “rate of return for the next year” - so it is It seems stupid to me too. For example: there is a 4-year tuition which grows at i=6%, the inflation = 3%, after tuition period there is no other expenses. But still they calculate the “rate of return for the next year” as = tuition*(1+6%)*(1+3%)
Maybe try to view it as a simplifying assumption to enable us to solve the problem without Excel in such a short span of time. At least that is the way I look at it…The addition of inflation rather than chain linking it is also techically incorrect but they allow it…The way I would try to answer your question and think about it is as follows: (first of all I basically agree with the manner you described it turkish_dude) 1.) I think they are kind of getting all the number into a common basis of next year to come up with a single hard number in order to calculate a return percentage. Hard numbers require their own unique period of time associated with them, and they are different for each time period, and so numbers must be converted into a percentage. Percentages are much less time specific i.e.–they can refer to per annum on a going forwards basis…So once you calculate a return percentage and then once you get everything into a percentage, then you can just add on inflation inflation percentage (and possibly investment management fees percentage, etc) on top of that and presto it will apply for time spans going forwards…kind of like per annum. I hope that helps.
Hiya Turkiya makes a very good point. I think that is why Schweser keeps mentioning that they left out the words “protect the principal” in the answer keys. If you think about it as “protecting the principal” it also becomes more clear. Thanks.
hiya it makes sense OK so if you only apply inflation to your expense, at the end of the year when it is taken out of your portfolio you will end up with 2,000,000 again. makes sense!! what was I thinking b4?