Background You are an investment advisor and your clients, Marilyn and David, re
ID: 2764617 • Letter: B
Question
Background
You are an investment advisor and your clients, Marilyn and David, require your services. Marilyn and David are both 65 and are about to retire. They have no assets other than $1,600,000 in cash savings, and they have no debts. They wish to maintain their current lifestyle during their retirement years. Their current annual living expenses are $120,000. They have no children and they do not wish to bequeath any assets to charity (after their death). Marilyn and David are in excellent health and have a normal life expectancy. They are, however, concerned about the possibility of outliving their retirement income (i.e., longevity risk). They will rely entirely on their cash savings to support themselves financially during their retirement years. Furthermore, they have a strong aversion to risk.
Marilyn and David have decided to use their cash savings to purchase an annuity that will provide them with the necessary income to cover their living expenses over their retirement years. They initially consult with Ms. Sheila Young who is an investment advisor at Merrill Lynch about purchasing their desired annuity. Ms. Young is a very experienced advisor and she claims that she could get Marilyn and David a much higher annual income than they require because she “knows” how to invest their savings in financial instruments that can yield at least 15% per year. This rate of return is well above the current and historical average return for U.S. stocks as measured by the S&P 500 index.
Marilyn and David want you to provide a “second opinion” of the analysis done by the Merrill Lynch advisor. Specifically, they want you to write a memo to Ms. Young that compares the two alternatives and highlights the risks and benefits of each alternative. They feel certain that Ms. Young is not giving due consideration to assumptions and variables that will impact their decision (e.g., market risk, the clients’ risk tolerance, life expectancy, among others), but they don’t know how to articulate their concerns to her. Therefore, since you speak “finance” they would like you to prepare this memo on their behalf.
Assignment
Write a memo to Ms. Sheila Young containing the following information:
Provide a professional and financially sound critique where you identify the problem(s), if any, with her investment analysis.
Conduct your own comprehensive investment analysis where you address any problem(s) identified using the appropriate methods (e.g., formulas, models, etc.) and assumptions; and provide the appropriate insight from your analysis.
Recommend one or more specific, clearly explained actions that address the problem(s) identified based on your investment analysis; and support your recommendations using your analytical results.
Grading and Instructions
The grade on this assignment will be equally divided (50/50) between the analytical quality of your argument (reasoning ability) and clarity of thought, correct use of grammar, punctuation, etc. (writing skills). Please note, simply providing “numbers” is insufficient to obtain a passing grade. Please provide your analysis in a clear and analytically sound memo that supports your final recommendations/conclusions. All supporting tables and graphs must be clearly presented and labeled.
Explanation / Answer
MEMO
Dear Ms. Sheila Young,
I am not under estimating the analytical knowledge and investment skills of yours since you are a senior investment adviser and working in a very reputed investment firm. You may be having your own investment plan which can generate more than 15% of annualized return. If I am sure, you are a most aggressive investor and with your latest information about new financial instruments You may think that you can generate more than 15% of annualized return to your clients. Your basic advise of investing in a portfolio of various asset classes and investment opportunities is plausible. Investing in annuities will generate very low return when compared with a portfolio of investments.
Here the main problem, I think is that you did not consider the important factors of the clients viz. age, risk tolerance of clients and also risk factors of individual instruments etc. If you consider all the factors, I think it may not be possible to generate an annualized return of more than 15%. Investment in Real estate, securitizations, International equities, US equities, international mutual funds, junk bonds etc. may generate high returns, but attract very high risks which are not preferable to risk averse investors and old aged clients. Government bonds, treasury bills, corporate bonds, bank fixed deposits, balanced mutual funds debt funds etc. may be exposed to less risk, but may not generate good returns. By taking into consideration the age of the Marilyn and David, I think it is better to strike a balance between the above mentioned two types of investment opportunities. But the portfolio, must generate at least 3% above the annuities investments.
Own Investment Analysis: By taking in to consideration the age and risk tolerance of the David couple, I am generating the below given analysis:
Integrated Asset Allocation strategies: The integrated asset allocation strategy separately examines: Capital market conditions and the investor’s objectives and constraints. These factors are then combined to establish the portfolio asset mix that offers the best opportunity for meeting the investor’s given the capital market forecast.
Integrated Asset Allocation:
1.Capital market conditions A Investor’s assets, Liabilities, net worth
2. Prediction procedure B Investor’s risk tolerance function
3. Expected returns, risk ,and C. Investor’s risk tolerance
Correlation
X. Optimizer
Y. Investor’s asset mix
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