Chapter 02 Asset Allocation Decision Questions 9 Problems 4

Ch 02 Asset Allocation Decisionquestions 9 Problems 4 5questi

Formulate an investment policy statement that outlines appropriate guidelines considering objectives and constraints based on Mr. Franklin's financial situation, goals, and assets. Recommend a long-term asset allocation aligned with this policy, explaining key assumptions used in its development. Additionally, analyze the growth of a $10,000 investment over 5, 10, and 20 years under different tax scenarios for individuals in the 36% and 15% tax brackets, considering both tax-exempt and taxable investment returns and appropriately calculating after-tax values.

Sample Paper For Above instruction

Introduction

In the realm of investment management, establishing a comprehensive investment policy statement (IPS) is fundamental for guiding future asset allocations and ensuring alignment with the investor's long-term goals and constraints. This paper develops an IPS for Mr. Franklin, a 70-year-old individual with substantial assets and particular philanthropic objectives. It further recommends an asset allocation consistent with this policy and analyzes the impact of taxation on investment growth over specified periods.

Part I: Investment Policy Statement

Mr. Franklin’s financial goals center on maintaining wealth for his philanthropic endeavors, specifically funding a medical research foundation, and preserving his estate for future needs. His active lifestyle and excellent health suggest a moderate risk profile, though his age warrants a cautious approach to protect capital while seeking reasonable growth. Constraints include his liquidity needs, tax considerations, and ethical preferences, given his philanthropic focus.

Objectives include capital preservation, income generation to support charitable commitments, and modest growth to offset inflation. Constraints involve his significant estate planning provisions, tax environment, and the illiquidity of certain assets like real estate and warehouse property.

Based on these considerations, the IPS emphasizes a diversified portfolio with an appropriate balance between growth and income assets, prioritizing stability and liquidity. It mandates annual review periods, consideration of tax implications, and adherence to ethical investing aligned with Mr. Franklin's philanthropic passions.

Part II: Long-term Asset Allocation Recommendation

Given Mr. Franklin’s profile and the stipulations of the IPS, a recommended long-term asset allocation might be as follows: 40% equities (including domestic and international stocks), 20% fixed-income securities (government and corporate bonds), 15% real estate and alternative investments (warehouses, other property), 15% cash equivalents for liquidity, and 10% in specialized assets or ethical investments aligned with his medical foundation interests.

This allocation balances growth potential with risk mitigation, emphasizing diversification, and liquidity, consistent with his desire for capital preservation and philanthropic funding. Assumptions include a moderate equity risk premium, inflation rate considerations, and expected returns based on historical data (Bodie, Kane, & Marcus, 2014).

In conclusion, the proposed asset allocation offers a strategic framework that aligns with Mr. Franklin’s objectives, risk tolerance, and constraints, supporting his philanthropic missions while safeguarding his estate.

Part III: Investment Growth under Different Tax Scenarios

For an individual in the 36% tax bracket earning 9% annually in a tax-deferred IRA, the future value calculations neglect taxes. The formula FN = P*(1+r)^t yields:

  • Five years: 10,000*(1+0.09)^5 ≈ $15,184
  • Ten years: 10,000*(1+0.09)^10 ≈ $23,579
  • Twenty years: 10,000*(1+0.09)^20 ≈ $59,944

When taxes are paid annually on the 9% return at 36%, the effective after-tax return is (1+0.09)*(1-0.36) ≈ 0.5856, leading to:

  • Five years: 10,000*(1+0.0856)^5 ≈ $15,754
  • Ten years: 10,000*(1+0.0856)^10 ≈ $24,762
  • Twenty years: 10,000*(1+0.0856)^20 ≈ $61,611

Similarly, for someone in the 15% tax bracket earning 10% on a tax-exempt IRA, the values are:

  • Five years: 10,000*(1+0.10)^5 ≈ $16,105
  • Ten years: 10,000*(1+0.10)^10 ≈ $25,937
  • Twenty years: 10,000*(1+0.10)^20 ≈ $67,275

When taxed annually at 15%, the effective return is (1+0.10)*(1-0.15) ≈ 0.885, thus:

  • Five years: 10,000*(1+0.085) ≈ $14,551
  • Ten years: 10,000*(1+0.085)^10 ≈ $23,631
  • Twenty years: 10,000*(1+0.085)^20 ≈ $56,269

This analysis underscores the importance of tax-advantaged growth, especially over long horizons, benefiting higher-tax-bracket investors more distinctly.

References

  • Bodie, Z., Kane, A., & Marcus, A. J. (2014). Investments (10th ed.). McGraw-Hill Education.
  • Brigham, E. F., & Ehrhardt, M. C. (2016). Financial Management: Theory & Practice. Cengage Learning.
  • Feldstein, M. (2017). The Economics of Tax Policy. National Bureau of Economic Research.
  • Gordon, R. H. (2018). Optimal Taxation of Capital Income. Harvard University Press.
  • Long, M. (2019). Investment Strategies for High-Net-Worth Individuals. Journal of Wealth Management, 22(4), 45-52.
  • Ross, S. A., Westerfield, R. W., & Jaffe, J. (2013). Corporate Finance (10th ed.). McGraw-Hill.
  • Sharpe, W. F., Alexander, G. J., & Bailey, J. V. (1999). Investments. Prentice Hall.
  • Treynor, J. L. (2012). Efficient Investment Management. Harvard Business Review, 89(2), 98-106.
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