Solution to first practice problem on CFAI txtbook page 145. The 2nd point asks to determine the return requirement. It’s 7.4%, I get it, but then the explanation of the problem says “Because the portfolio’s expected return of 7.4% translates to a real return of approximately 4.4%, the portfolio is NOT expected to meet the return requirement of 4.5%” Why 4.5% (50,000/1120000) is in real terms but 7.4% (82500/1120000) is in nominal terms? I think CFAI txt is getting a lot of people confused about real vs nominal return requirements in Reading# 14 “Managing Individual Investor Portfolios”.
Hopefully this is just a question illustrating the importance of taking inflation under consideration? While it is close in this question i imagine the exam (with only three possible answers) will be more clear cut. Kudos to you for studying CFAI though. I have found that the concepts covered in CFAI that are covered on the exam are actually tested in more basic terms and situations (hence the oversupply of 3rd party study providers. they all think they can game the exam) anyways, this isnt really a good answer since i dont have my books in front of me so sorry.
portfolio returns are estimated using nominal. Expenses are estimated using real ( i.e. after inflation )
Assuming we adjust expenses for inflation (so plus inflation) and divide them by the portfolio value, we always get a real rate of return? But I still don’t get the CFAI practice exam above because 50,000 expense is not adjusted for inflation but we are still getting a real rate of return. I am confused.
If you ignore her portfolio return of 82500, she will have 50000 in income and 100000 in expenses. So, she currently has a shortfall of 50000. She needs 50000 per year to cover these additional expenses (50000/1120000=4.5.). Both the 50000 income and the expenses of 100000 will move with inflation (meaning the shorfall will also increase each year). So, she needs a REAL return of 4.5%. The portfolio return of 82500 can be broken into two components. 1. related to inflation(1120000*1.03=33,600 or 3%) 1. real return (82500-33600=48900 or 4.4%). My guess.
Thanks for the reply. I understand that the REAL return requirement is 4.5% with 50,000 in expenses. But then the return requirement when using expenses of 82,500 should be 7.3% in REAL terms, however the txt considers that return in NOMINAL terms because it subtracts inflation to calculate the REAL return. It’s dilemma to me.
actual portfolio returned 82500… which works out to 7.4% (82500/Investable Assets). This is the nominal return. subtracting the inflation from that – gives you the real return provided by the portfolio to be 4.4% (or less if you did 1.074/1.03 - 1) and this is less than the REQUIRED real return of 4.5% (calculated as 50000/Investable Assets). So the realized return is < than the required return. 82500 is the Nominal return… not the real return (because that is what the portfolio actually returned).
The portfolio returned 82500 because that’s the return requirement. It’s the difference between expenses of 132500 and 50000 income. So real, not nominal return. If expenses increase with inflation (3%), then the portfolio must generate a rate of return on 10.3% to keep up.
they did not say that it is the return requirement. they said it Expected Total Return would be 82500.
That is the return requirement. 132500 in expenses minus 50000 in income gives you 82500 needed from the portfolio. If the portfolio doesn’t generate that cash, then the individual cannot live.
you get 82500 in a year (not today). how is that a real return? 100000 in expenses (read the question), 50000 in income. So you need 50000 in today dollars each year going forward to cover the shortfall. Cant do this with a 82500 nominal return. I sorta think you are joking.