Super tough CFA Level 3 question (kind of a trick question)

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bananaman1

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Hey everyone! For extra credit, I need to answer this question knowing that it is very hard but whoever is closest will get the most credit. Please help me! Here is the question:
Imagine that you have just acquired a new client, Mrs. Brooks. Mrs. Brooks is 75 years old, has a $25 million investment portfolio, and her living expenses are $170 thousand per month. She has no other income source. Her portfolio asset allocation currently is 40% in U.S. large cap equities, 10% in U.S. small cap equities, 10% in international developed markets equities, 10% in emerging markets equities, 25% in 1-year maturity municipal bonds, and 5% in gold. Mrs. Brooks fired her former investment advisor because she was unhappy with her portfolio’s volatility and because the size of her portfolio has decreased significantly over the past three years. Mrs. Brooks had a bad experience with a hedge fund at one point during her life, so she won’t invest in a hedge fund ever again. Mrs. Brooks does not like investments with long lock-ups. Her stated risk tolerance is quite low; in fact she mentioned during the client-intake process that she gets quite upset if her portfolio has a negative return of greater than 0.1% per month. How would you go about building a portfolio for Mrs. Brooks or what investment portfolio/strategy would you recommend for Mrs. Brooks? How would you explain your recommendation to her?
 
Just to clarify: Living expenses $170 thousand per month or per year?
 
If it’s $170k per month, then that requires a post tax return of just over 8% a year.
With her low risk tolerance and not wanting to lose more than 0.1% a month, this would steer the investments towards money markets or quality corporate & government bonds.
Without the stated returns on the asset classes it makes it impossible to know what asset mix to use that could meet the required return.
At her age, unless she has any bequest requirements, she may as well put the proceeds in Tbills and run the capital down. Again we need a little more background to the IPS to understand her requirements.
 
Per month! That is what is making this so hard!
Thanks for any help you can give me.
 
haha maybe that should be my answer :)
Any idea on how to set up her portfolio ?
 
Thank you so much for your response and help! I know we need more information to give an asset mix, but can you please help me in coming up with rough numbers? Like how much in corp bonds, gov bonds, money markets, etc? Just a rough breakdown please.
 
Thank you so much for your response and help! I know we need more information to give an asset mix, but can you please help me in coming up with rough numbers? Like how much in corp bonds, gov bonds, money markets, etc? Just a rough breakdown please.
 
Your client is essentially asking for an investment to deliver ~8% annual AFTER-TAX return with virtually no downside risk. Not possible, unless you knew Madoff back in the 90s.
 
Actually, if you assume that she’s going to last only another 25 years and doesn’t need to maintain the corpus, it’s only 6.78% after taxes: an annuity.
 
Thanks for the answer! Can you give me some more insight though on how you would set up a portfolio to get that return and what percentage in each type of asset? Thanks so much ! This will really help me.
 
Apart from an annuity (as the magician suggested), it is *impossible* to provide that kind of return without any potential downside risk – no matter what your asset allocation may be.
This Mrs. Brooks sounds like a real piece of work… a selfish, unrealistic old hag who wipes her a$$ with hundred dollar bills, but doesn’t truly understand that you need to take *some* risks in order to earn a rate of return that is materially greater than the rate of inflation. You can tell her that I said that.
 
I think you should take a closer look at her behavioral biases and, if appropriate, educate her about risk - return concepts.
 
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