Jill Jones inherited a large lump sum of money. This lump sum will represent the total of her investable assets and will need to be invested in a way that will support her spending needs in retirement. Jill has brought the personal finance documents you requested to the meeting, completed a risk questionnaire and spoke with you about her retirement objectives.
In preparation for the next meeting you use the information you have gathered to assess Jill's goals in light of her risk tolerance, risk perception, risk capacity, and other personal and financial circumstances. Balancing all of these factors, you have decided that a diversified portfolio with moderate risk is the reasonable approach to sustaining Jill's spending needs in retirement. You know that you will need to engage in extensive explanations and education to ensure that Jill will remain comfortable with the recommended portfolio over the long run.
1. Construct an optimal client portfolio by the allocation of wealth amongst risky assets and risk-free securities. Diversify the portfolio among a dozen asset classes instead of thousands of individual securities.
A. Refer to Table 1.0 to see nine Assets Classes, Annual Returns, Standard Deviations and Sharpe Ratios
B. Select four Asset Classes to include in the client's portfolio.
C. Determine the what percentage the Asset Class will represent in the client's portfolio.
D. Construct a weighted average for the investor's portfolio consisting of the four Classes of Assets, their weights in the portfolio, and annual returns earned.
E. Calculate the expected weighted average return on the investor's portfolio (see Table 2.0 for an example). Include the Standard Deviations and Sharpe Ratios.
2. Is the investor's portfolio less risky than the benchmark(s)? (Please see Table 3.0 for the names of the Benchmarks for the asset classes.)
3. Is the asset allocation strategy consistent with the client's risk tolerance?
4. What would you say to Jill Jones to recommend the investor's portfolio?
Table 1.0 Examples of Annual Returns, Std Deviations, and Sharpe Ratios
|
Returns & Risk
1977-2011
|
Ann
Returns
|
Standard
Deviation
(Risk)*
|
Sharpe
Ratio**
|
|
|
|
|
|
|
Tbills
|
2.8%
|
2.1%
|
-
|
|
Bonds
|
5.8%
|
2.9%
|
1.03
|
|
US Lg
|
5.7%
|
20.4%
|
0.14
|
|
US Sm
|
6.2%
|
20.6%
|
0.17
|
|
REITs
|
9.2%
|
22.7%
|
0.28
|
|
Intl Lg
|
3.4%
|
23.1%
|
0.02
|
|
Intl Sm
|
6.0%
|
28.1%
|
0.11
|
|
EM
|
7.1%
|
38.5%
|
0.11
|
|
Portfolio
|
6.6%
|
15.5%
|
0.24
|
|
|
|
|
|
|
*Higher standard deviation indicates higher volatility of returns.
** The Sharpe Ratio measure return and risk efficiency. A higher number indicates better risk adjusted performance.
|
Table 2.0 Weighted Average Returns in Example Portfolo
|
Selected Asset Classes
|
Weight inPortfolio
|
Return
|
|
US Lg
|
40%
|
1.12%
|
|
Bonds
|
30%
|
1.74%
|
|
Intl Sm
|
20%
|
1.20
|
|
EM
|
10%
|
.71%
|
|
Portfolio
|
100%
|
4.77%
|
Table 3.0 Benchmarks for Asset Classes
