Gary Lee Weinrib (Mr. W) is a 60 year old divorced musician. He is planning on retiring in the next two years. He will quit touring and recording. He is in reasonably good health. As a successful musician, he has amassed a solid portfolio. His net assets are $10 million. His current earnings are $500,000, and his expenses will be $500,000 in retirement. His current income consists of $250,000 touring income and $250,000 of income from record royalties.
1. Write an Investment Policy Statement covering Mr. W’s Objectives and constraints. Be sure to cover the client’s return requirements, time horizon, tax considerations, inflation concerns etc.
2. What is a potential concern regarding royalty income from a retiring musician that may need to be addressed?
3. What investment class (equity, fixed income, real estate etc.) do the royalty payments mimic? Why?
4. Mr. W informs you that at retirement he plans to move from California, a state with high income taxes to Texas, a state with no income tax. How does this impact his objectives and constraints?
5. Mr. W. informs you that he has a 30 year old special needs child that will need special care after his death. He has contingency plans for caregivers and figures this will require an expense of around $100,000 per year. How does this impact the time horizon of the portfolio and its risk/return requirements? What about sensitivity to inflation?
6. Mr. W’s nephew is starting in the investment business and he wants to invest $1million with his nephew to help him out. His nephew manages an active equity fund denoted by portfolio “D” shown below. What would you recommend to Mr. W? Where would you document the investment in the IPS if it is made? What is another way of looking at the investment – what could it be considered as opposed to an investment?
7. You’re pretty amazed when Mr. W shows up with a plot of his indifference curve, but being schooled in the ways of Modern Portfolio Management, right away you plot it with the efficient frontier as shown below. Which portfolio is optimal for Mr. W & how do you know that?
8. Mr. W grows concerned when you recommend two “risky” investments for his portfolio. “Look at the size of those standard deviations!”, he says. “One of those is risky enough, if I own them both, I’m taking on even more risk.” Explain why this may not be not the case. Under what circumstance would he be correct? Be sure to address the issue of covariance/correlation.
9. After your eloquent explanation, Mr. W figured he’d read up on MPT. After learning about the Sharpe CAPM, he tells you he wants a high beta portfolio because that will get him more return. He says that Sharpe’s CAPM implies that more risk = more return. Is he right or wrong? Explain.
10. You have calculated the expected returns and Betas for a universe of stocks to consider for inclusion in Mr. W’s portfolio. Using that data and the resulting Security Market Line (SML) below, which stocks should be included? Which stocks should be sold? Why?
11. Mr. W was saying that he was a little concerned last year when his portfolio dropped 30%, but he says at least he’s back to even since his portfolio has returned 30% this year. Is he correct? Why or why not? Using a portfolio of $10 million, demonstrate your answer.
Bonus question – After reading Risk: The Hottest Four- Letter Word in Financial Markets by Bernstein and Risk Revisited by Howard Marks (Both are in Doc share), Explain why the statistical measures of risk such as standard deviation and beta may not give an investor the whole picture of the risk they are taking? What are alternative ways of looking at risk suggested by the authors? What is your opinion as to how risk should be evaluated?