4 given its value as an alternative to stocks and

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4. Given its value as an alternative to stocks and bonds as a way to maintain real return and provide diversification benefits, real estate could be included in this portfolio. In a long term context, real estate has provided good inflation protection, helping to protect real return production. An example of an appropriate, modestly aggressive allocation is shown below. Table 28H contains an array of historical and expected return data which was used to develop real return forecasts. In this case, the objective was to reach a spending level in real terms as close to 6% as possible, a level appearing to meet the dual goals of the committee and that is also feasible. The actual expected real portfolio return is 5.8%. Intermediate Term Forecast of Real Returns Recommended Allocation Real Return Contribution Cash (U.S.) T bills 0.7% *0% Bonds: Intermediate 2.3 5 0.115% Long Treasury 4.2 10 0.420 Corporate 5.3 10 0.530 International 4.9 10 0.490 Stocks: Large Cap 5.5 30 1.650 Small Cap 8.5 10 0.850 International 6.6 10 0.660 Venture Capital 12.0 5 0.600 Real Estate 5.0 10 0.500 Total Expected Return 100% 5.815% *No cash is included because ongoing cash flow from the portfolio should be sufficient to meet all normal working capital needs. 8. a.The Maclins’ overall risk objective must consider both willingness and ability to take risk. Willingness : The Maclins have a below-average willingness to take risk, based on their unhappiness with the portfolio volatility in recent years and their desire to avoid shortfall risk in excess of –12 percent return in any one year in the value of the investment portfolio. 28-15
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Chapter 28 - Investment Policy and the Framework of the CFA Institute Ability : The Maclins have an average ability to take risk. While their large asset base and a long time horizon would otherwise suggest an above-average ability to take risk, their living expenses (£74,000) are significantly greater than Christopher’s after-tax salary (£48,000), causing them to be very dependent on projected portfolio returns to cover the difference, and thereby reducing their ability to take risk. Overall : The Maclins’ overall risk tolerance is below average, as their below-average willingness to take risk dominates their average ability to take risk in determining their overall risk tolerance. b. The Maclins’ return objective is to grow the portfolio to meet their educational and retirement needs as well as to provide for ongoing net expenses. The Maclins will require annual after-tax cash flows of £26,000 (calculated below) to cover ongoing net expenses, and they will need £2 million in 18 years to fund their children’s education and their own retirement. To meet this objective, the Maclins’ pre-tax required return is 7.38 percent, which is calculated below. The after-tax return required to accumulate £2 million in 18 years, beginning with an investable base of £1,235,000 (calculated below) and with annual outflows of £26,000, is 4.427 percent. When adjusted for the 40 percent tax rate, this results in a 7.38 percent pretax return: 4.427%/(1 − 0.40) = 7.38% Annual Cash Flow = –£26,000 Christopher’s Annual Salary 80,000 Less: Taxes (40%) –32,000 Living Expenses –74,000 Net Annual Cash Flow –£26,000 Asset Base = £1,235,000
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