Cliff Swatner is single, 33, and owns a condominium in New York City worth $250,000. Cliff is an attorney and doing well financially. His income last year exceeded $90,000, and he has sufficient liquid assets to supplement his condominium and other tangible assets. Several years ago, Cliff began investing in stocks and bonds. He made his selections on the basis of articles he read describing good investment opportunities. Some have worked well for Cliff, but others have not. Cliff has never taken the time to evaluate his portfolio performance, but he feels it isn't very good. Cliff currently has about $90,000 invested. He has been dating a woman lately and hopes to marry her in three years, at which time he will need $20,000 for marriage expenses and a honeymoon. Cliff's only other objective is to accumulate funds for retirement, but he does not have a specific dollar target for this goal. Cliff feels that he has a moderate risk-tolerance level.
1) Explain some disadvantages of Cliff's current investment approach.
1.Not keeping track of investments - Having made the investments Cliff should have kept a track of them. He should hold on to the investments that are doing well and sell the ones that are not.
2.Investing without any specific targets or thoughts - each investment made should be linked to the purpose and the time of investment. Different investments have different risk and return characteristics and these should be kept in mind while investing
3.No Dollar amount as target - while investing, it is essential to have the final value that one wishes to get. Based on these and the expected returns, a monthly allocation can be made. Without the target, it is difficult to put aside any amount of money.
4.Diversification - The money has been put in bonds and stocks. The portfolio should ideally be a diversified portfolio so that the volatility in returns is reduced. This means that he should include some low risk securities such as Treasury Bills
2) Construct a portfolio for Cliff, limiting your selections to mutual funds (assume that he sells his current stock and bond holdings). Make sure your plan indicates specific dollar amounts for each portfolio component. Make sure your plan also explains your selections for each portfolio component.
Advantages of Mutual Funds:
• Professional Management - The primary advantage of mutual funds (at least theoretically) is the professional management of your money. Investors purchase funds because they do not have the time or the expertise to manage their own portfolio. A mutual fund is a relatively inexpensive way for a small investor to get a full-time manager to make and monitor investments.
• Diversification - By owning shares in a mutual fund instead of owning individual stocks or bonds, your risk is spread out. The idea behind diversification is to invest in a large number of assets so that a loss in any particular investment is minimized by gains in others. In other words, the more stocks and bonds you own, the less any one of them can hurt you. Large mutual funds typically own hundreds of different stocks in many different industries. It wouldn't be possible for an investor to build this kind of a portfolio with a small amount of money.
• Economies of Scale - Because a mutual fund buys and sells large amounts of securities at a time, its transaction costs are lower than you as an individual would pay.
• Liquidity - Just like an individual stock, a mutual fund allows you to request that your shares be converted into cash at any time.
• Simplicity - Buying a mutual fund is easy
Cliffcan invest the $90,000 as follows:
1.He should invest in a fixed income mutual fund, ideally a fixed income plan, which would give him $20,000 at the end of three years, which is required for his marriage. Since the current rate is 4%, the amount to be invested comes to $17,780 (Present value of the $20,000 needed after 3 years at a discount rate of 4%).
2.The remaining amount should be invested in mutual funds which have a moderate risk profile.
Cliff Swatner should invest in following mutual funds:
· AIM$6,000· Alliance $6,000· American $5,220· Columbia $7,000· Dreyfus$8,000· Eaton Vance $10,000· Federated $20,000· Fidelity $5,000· Franklin Templeton $5,000
You should consider the investment objectives, risks, charges and expenses carefully before investing in mutual funds.
3) Explain how Cliff should periodically rebalance his portfolio, indicating how frequently rebalancing should be done.
Rebalancing the portfolio means moving from risky assets to safer assets as you time passes. The logic behind that is that an investor would not like to lose capital as he grows older, since the sources of income would be limited. As people approach retirement, they tend to become more risk averse. Their investment strategy also tends to emphasize capital preservation. This increased conservatism is a very normal response. However, this shift in risk tolerance requires that you rebalance your portfolio.
Rebalancing is the process of buying and selling portions of your portfolio in order to set the weight of each asset classback to its original state. In addition, if an investor's investment strategy or tolerance for risk has changed, he or she can use rebalancing to readjust the weightings of eachsecurity or asset classin the portfolio to fulfill a newly devised asset allocation.
Cliff should follow the following guidelines when rebalancing his portfolio (By Investopedia):
The optimal frequency of portfolio rebalancing depends on your transaction costs, personal preferences and tax considerations, including what type of account you are selling from and whether your capital gains or losses will be taxed at a short-termversus long-term rate. Usually about once a year is sufficient; however, if some assets in your portfolio haven't experienced a large appreciation within the year, longer time periods may also be appropriate. Additionally, changes in an investor's lifestyle may warrant a change to his or her asset-allocation strategy. Whatever your preference, the following guideline provides the basic steps for rebalancing your portfolio:
- Record -If you have recently decided on an asset-allocation strategy perfect for you and purchased the appropriate securities in each asset class, keep a record of the total cost of eachsecurity at that time, as well as the total cost of your portfolio. These numbers will provide you with historical data of your portfolio, so at a future date you can compare them to current values.
- Compare - On a chosen future date, review the current value of your portfolio and of each asset class. Calculate the weightings of each fund in your portfolio by dividing the current value of eachasset classby the total current portfolio value. Compare this figure to the original weightings. Are there any significant changes? If not, and if you have no need to liquidate your portfolio in the short term, it may be better to remain passive.
- Adjust -If you find that changes in yourasset classweightings have distorted the portfolio's exposure to risk, take the current total value of your portfolio and multiply it by each of the (percentage) weightings originally assigned to each asset class. The figures you calculate will be the amountsthat should be invested in eachasset classin order to maintain your original asset allocation. You may want to sell securities from asset classes whose weights are too high, and purchase additionalsecurities in asset classes whose weights have declined. However, when selling assets to rebalance your portfolio, take a moment to consider the tax implications of readjusting your portfolio. In some cases it might be more beneficial to simply not contribute any new funds to the asset class that is overweighted while continuing to contribute to other asset classes that are underweighted. Your portfolio will rebalance over time without you incurring capital gains taxes.
Conclusion
Rebalancing your portfolio will help you maintain your original asset-allocation strategy and allow you to implement any changes you make to your investing style. Essentially, rebalancing will help you stick to your investing plan regardless of what the market does.