Can someone intuitevely explain this?! Every question I try and answer is phrased differently… i.e. question 2 in reading 8 of the EOC. I get i’m suppse to add inflation when to maintain purchasing power on top of the return that needs to be generated, but HOW CAN I GET THIS RIGHT EVERY TIME WITH THE LITTLE TRICKS THE CFA USES TO CONFUSE PEOPLE! Please help. thanks!

Hi,

I agree that it is annoying to have to guess what return is the target variable…

In Q2 R8 EOC, from my understanding, there are two possible " return requirements"

One could work with the “nominal return requirement” which, in this example is 50/1120+inflation = 7.46% and compare that “nominal return requirement” with the "expected portfolio return " of 82.5/1120=7.4%

They worked instead with the “real return requirement” of 50/1120=4.46% and compare that to the “expected real return” = "expected portfolio return " -inflation =4.4%

If there is no precision in the question of the AM exam, i will simply explain clearly in my answer what is my target.

From what i have seen in previous AM exam (did not do a lot yet) , it is clearly stated :

For example, I highly recommand doing Q1 of AM 2013 exam in two different ways and then look at the answer.

“Determine the Voorts’ **nominal after-tax required rate of return** for the coming year.”

**First method,**

Estimate how much return do you need to keep the purchasing power of the investment portfolio (11M)

Since inflation is 2.5%, you need to gain 275K

On top of that, you need to cover inflated expense for next year ( minus after tax income) = 220K

=> nominal return need to be (220+275)/11000 = 4.5%

**Second method**

Forget about keeping the purchasing power of the investment portfolio

Just calculate the return you need to cover inflated expense = 220/11000 =2%

Then use the Equation **Real Return = Nominal Return - Inflation**

=> Nominal return = Real return + Inflation = 2 +2.5=4.5%

Hope that helps.

Thanks for your response

The thing that is confusing to me is that if inflation averages 3% annually, i would assume that the portfolio needs to be increased by an 3% in order to keep up with the increase in christa’s expenses. therefore i would assume that the return requirement is already in "real"terms.

Example:

Christa’s expenses = $82.5

Investment portfolio = $1,120

Return Requirement = 82.5/1120 = 7.4% (rounded)

**Inflation is expected to be 3% per the question**

Expenses increased by inflation = 82.5 * (1.03) = 85 (rounded)

**In order to maintain her purchasing power (i.e. maintain a return that is sufficient enough to keep up with the actual REAL expense)**

The portfolio needs to increase by the rate of inflation so therefore we have

(82.5*1.03) / (1,120*1.03) = 7.4% THIS IS THE REAL RETURN the inflation return is **3% and cancels out in order to maintain her purchasing power, you still have the same amount of expenses.**

**My conclusion, based on this logic is that the return requirement was already in real terms and in order to keep up with inflation it needs an inflation component of 3% added.**

THE QUESTION DOESNT SAY LAST YEARS EXPENSES IT SAYS THIS YEARS EXPENSES (NO INDICATION THAT INFLATION WAS IN IT)… it is very confusing and i feel not worded appropriately to understand unless I just don’t understand it.

Are you going to add additional inflation to something that you spent in THIS YEAR???