Guys, I am having a tough time formulating IPSs esp. the objectives…I end up getting strange but close reqd. return numbers - i get jumbled with the inflation part AND risk a lot of questions that said above average I said below average and vice-versa. With constraints part I am okay. Anybody feel or experience the same or any suggestions/rules of thumb on calculating the required returns will be helpful. Thanks,
For people who need the income right away to cover expenses, it’s pretty straightforward. Required return = year 1 net expenses (after offsetting income) divided by investable assets (after taking out for immed or short term cash needs). That’s a real return since expenses will go up. (Just add inflation, don’t try to get fancy and compound it.) It’s also after tax since you have to have the money in hand before you pay your bills. (Divide by 1-T to get before tax.) If you don’t get what I’m saying, throw the numbers (with a given rate of return) in a spreadsheet, you’ll see how they inter-relate, then you can understand how to do the calculation backwards to get the rate. When the guy needs the money later and not right away, then it gets tricky, and CFAI doesn’t explain it very well. There are several instances where you have to create an equation and solve for the required rate of return. But you have to solve recursively, which is not shown anywhere. You’d use this technique for Susan Fairfax (CFAI didn’t do this and their answer as a result is wrong IMHO.) You also use it for Reading 15, Question 13, to get the 7.38% (answer key in the Apx says the solution is shown, but it’s not). For risk, think two ways – willingness and ability. Usually willingness trumps ability.
Yeah, that Q13 was indeed tricky…I just did it as two separate parts and left it at that… anyways, if you could comment on the simple example below it would be useful: a guy has now $1,000,000 and makes $100,000 every year and has expenses of $120,000 per year. Both salary and expense grow at inflation i=3%. Assuming there is no other inflow or outflow and he is single and will do so for the rest of his 30 year work life. So, reqd. return = [Year1 (net of inflow and ouflow)+ inflation]/asset base = 20,000/1,000,000 = 2% and to this add 3%, Thus Reqd ret = 5% Is this correct? What are your thoughts on, Question 7 in concept checkers in Schweser (Bonnie DuBois) and question 10 in CFAI Reading 15 (Robert Taylor) Thanksmuch
I agree with 5%, up to retirement. Then it becomes something higher. Alternatively, you work into calc enough additional return during working lifetime to support higher level of net expense after retirement. Mathematically this is doable, but I’m not sure CFAI would expect us to do 30 year planning for retirement. But if he were only 5 years away from retirement, I think it would be expected. Haven’t looked at Schweser yet, can’t help you with Bonnie DuBois. I agreed with CFAI solution for Taylor. Only thing that bothered me was they described inflation expectation for NEXT YEAR as 1%, then used it as a long term expectation. Did you have any other specific issue with the solution?
Oh, with Q 10 CFAI, I realized now that the inflation data is not given and hence you use real after tax expenses to calculate the reqd. return… But, I GUESS otherwise I am okay for now, thanks… Man(or woman), the next few readings are so boring on multiple asset allocations and tax efficient investments…I was hoping to finish SS4 today but seems unlikely… I haven’t started SS5,6,7 or 18…whoa!
BTW, there’s errata posted for Q10 solution, if you haven’t seen it.