Essay on "Investment Strategy Project"

Essay 25 pages (6691 words) Sources: 5 Style: Harvard

[EXCERPT] . . . .

Investment Strategy Report

Index

Beatrix and Karl are breaking even and have little savings. Their expenses in retirement, depending on estimates, could leave them with a deficit as their only source of non-investment income is Karl's pension. Therefore, the portfolio will be constructed with income generation in mind. The couple has a low risk tolerance and a short time horizon. They have three years until retirement that they can use to build the portfolio before they may have to start taking out. Their income needs may range from zero to €7000 per annum. Their budget does not include any abnormal expenses, but those will be included in our calculations, and we are seeking a portfolio that can generate €10,000 a year for the couple.

Because there is a strong need for liquidity, 10% of the portfolio will be in money market. The couple has the option to reduce this to 5% (€10,000) but it is advised that they do not. The couple has a low risk tolerance, but needs to make some long-term gains in order to meet financial needs closer to the end of their retirement. Thus, 20% of the portfolio will be in equities. This will come in the form of a highly regarded index fund, giving non-systemic risk at a fair price.

The remaining portfolio will be 30% corporate bonds and 40% government bonds, so mix safety with returns. These will be staggered such that the couple is always within a year of another maturity. No initial maturities will be less than 3 years. Once the couple retires, the proceeds of their home sale will be added to the portfolio and duration of the bond portfolios will tighten. The portfolio will generate in the range of €10,900 per year in retirement, sufficient even to meet the worst-case estimates of spending.

Chapter 1

Beatrix is fifty-seven years old and lives in Munich with her husband Karl. She works part-time as an administrative assistant. Her husband is a purchasing manager. Karl will retire from his position in three years' time with a full pension. Beatrix is expected to retire at this time as well, since they are selling their home in Munich and relocating to a small village. While there are villages on the Munich metro line, we will assume that Hans does not live within commuting distance. Beatrix is unlikely to find meaningful part-time work in the village so should expect to retire when they sell their house. Demand for housing in Munich is relatively strong so they can probably move their house quickly upon Karl's retirement.

The couple have limited financial resources but also limited needs. They have £20,000 remaining on a variable rate mortgage in the UK. They also need income for their cost of living. Their children have grown, so there is no immediate need to support any of the family. The couple intends to visit Paris in three years at a cost of €8000 but have few other major travel plans.

In terms of resources, Beatrix and Karl have just the remaining three years of income and modest savings of €10,000 cash. Neither has any stocks and therefore cannot be considered sophisticated investors. With their age and lack of investment knowledge, Beatrix and Karl can be expected to have a low risk tolerance. When they retire, they will sell their Munich house and purchase a house in the village, generating approximately €60,000 in free cash flow, net of sales fees.

Between the income earned over the next three years, Karl's pension and the profit on the swap of the houses, Beatrix and Karl can reasonably expect to have some savings stockpiled for their retirement. They have only modest ambitions for travel and expect to live an inexpensive Bavarian village life. Dinner for two with beer in such a village costs less than €15, for example. Aside from the occasional return to Munich for cultural events, month-to-month expenses for the couple can reasonably be covered by the pension. The savings, therefore, is to be used mainly for exceptional expenses.

That Beatrix and Karl are expected to have a sound financial footing for their retirement, they can view their inheritance in one of two ways. They can view it as a backup fund, in case of emergency. For example, to help out family members such as their relatives in Texas who could lose their health care benefits or have their home destroyed by a hurricane. They could use it as backup for themselves, in case retirement expenses are greater than expected. The other way to view the inheritance money is as money that if managed properly can flow through to their children.

The couple could also view the money as both -- financial backup for themselves or their family members in the case of crisis, but if it is not needed then it would become inheritance. In either case, Beatrix and Karl are in an advantageous position. Although they are not wealthy, their spending ambitions match their spending capabilities. This money is not needed immediately, but could prove valuable. With limited financial knowledge, Beatrix and Karl will not want to take great risks with this money, so the investment strategy must be drawn up with that in mind as well.

Chapter Two: Executive Summary

Beatrix and Karl have adequate cash flow. They have a minor shortfall at present owing to their mortgage in the UK. Using fairly conservative estimates, they will face a shortfall in their first two years of retirement as well. When the mortgage is finished, they will have a modest surplus. Sensitivity analysis shows that if their spending levels are higher than anticipated, they will run a deficit. However, the inheritance provides them with enough money to last the remainder of their lives. These estimates do not include large expenses, such as additional vacations beyond Paris, nor do they take into consideration the inheritance the couple may wish to leave their children. Although the couple has a relatively healthy financial position, they will need to find suitable investments for the inheritance money in order to meet their needs and reduce their financial risk.

Chapter Two: Future values and risk

Beatrix and Karl's cash flow situation is adequate. It is assumed that they have been, more or less, breaking even with their inflows and outflows. To be conservative, it will be assumed that Beatrix will only earn €15,000 for each of the next three years. This hedges against economic downturn and it also assumes she will wish to slow down, in order to transition into retirement. The couples combined income for the next three years will then be €70,000 per year.

In terms of outflows, they have their living expenses, their mortgage in the UK and savings. Their living expenses are expected to decline, now that their last dependent child has moved out. If we assume this child cost them an average of €400 a month in food, extra utilities, gasoline and sundry school expenses, that money can be put towards savings.

The UK mortgage is worth £20,000 and is variable rate. Interest rates in the UK are low, and expected to remain there for some time in order to spur economic growth. The rate we will conservatively estimate at 5%. The time frame for this mortgage is unknown at present. If we assume that they would not have taken on a mortgage for more than a few years past retirement, then five years remaining can be assumed. This gives a mortgage payment of £378 per month, or £4529 per year. That equates to €5077 at current exchange rates.

To estimate post-retirement living expenses, their current expenses must be analyzed and then adjustments made to reflect the realities of post-retirement life. The couple broke even on €70,000 per year. It is estimated that post-retirement cash flow needs are between 60-80% of pre-retirement needs. At the lower end of the income scale, the lower figure can be used, since government benefits make up a greater portion of post-retirement cash flow (Ibbitson, et al., 2007). The cost of living in rural Bavaria is also much lower than the cost of living in Munich, by 20-30% on many key consumables such as food. Transportation costs are also lower in the villages due to their small size and complex bicycle networks. Therefore, it is a reasonable expectation that 60% of pre-retirement income will be required by Beatrix and Karl in order to survive. The couple will also benefit from the presence of their son and his family, who will be able to help them in their later years, further reducing costs. However, since 60% is at the very low end of the range, it is more conservative to utilize an estimate of 65% or 70%.

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