Investment Strategy Report Index Beatrix Essay

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9% for the past seven years (Index Mundi, 2009). An inflation rate of 2% per annum shall be assumed for our future cash flows model, the additional 0.1% reflecting a desire for conservativeness in our estimates.

Karl's pension pays him 80% of his current salary, which is not expected to increase in the final three years. The pension benefit is indexed to inflation. We will assume a 30% tax rate for both pre- and post-retirement income.

The couple is breaking even at present, with a surplus of €264 expected for 2010. This assumes minimal work for Beatrix, so anything she works above and beyond the €15,000 threshold will allow the couple to save more money for their retirement. With no raises and no additional work from Beatrix, the couple will run a small deficit for their last two working years.

In retirement, the couple will not make enough money to support themselves. Their income will be reduced considerably, given that Beatrix' income will disappear entirely and Karl's will be reduced by 20%. The expected reduction in living expenses will just barely accommodate for the reduced earning power. The couple's future cash flow statement looks as follows:







Future Values


























Net Income











Living Exp








Surplus (shortfall)






When the couple enters retirement, they will face an annual shortfall of around €4700-€4800. This chart clearly illustrates the most pressing financial problem for the couple -- their UK mortgage. This is a drain in excess of €5000 per year for the next five years. This hampers their ability to add to their retirement savings. In their first two years of retirement, they will face a shortfall in excess of €4700, which is entirely attributable to the UK mortgage. Without that mortgage on their books, they would be in a much stronger financial position.

To meet these needs, the couple will have approximately €60,000 in profit from the swap of houses, and the inheritance. The current savings of €10,000 is likely to be spent on the Paris vacation and therefore should not be considered as funds available for retirement. The above calculation indicates that the couple is actually unlikely to save any more money prior to retirement under their current situation.

However, their expected annual surplus is only €300. This cuts a fine line. For example, using the same spreadsheet if the savings required jumped to 70% instead of 65%, the couple would face a shortfall in the first two years in excess of €7000 and in the remaining years the shortfall will be over €2000. If the couple's costs are much higher than expected, at 80%, they will face a shortfall of nearly €12,000 for the first two years and around €7000 thereafter. These figures do not include major expenses such as travel, vehicles, gifts to children/grandchildren and other potentially sizeable outlays that are not a part of the couple's current spending patterns but could be as retirees.

Germans live, on average, to be. £200,000 is worth €223,896. If the inheritance is not invested, and the couple's will easily have enough to last their retirement. However, they may wish to consider the amount of money they would like to leave their children and grandchildren.

It is determined then that the couple needs to invest the inheritance money in a manner that allows them to meet their income needs. The couple is in a good position, whereby it can probably earn enough with the returns on the inheritance to leave the principle for large expenditures and to leave behind.

The couple does need to consider the financial risk that they have. Their retirement income is going to be fixed, which means that their budget is going to be highly sensitive to spending. If their spending levels are higher than they expect, they will not likely spend all of the inheritance money, but with a few big ticket items they may find themselves with nothing to leave behind.

The average life expectancy for Germans is 79 years at birth, which equates more to 83 or 84 for a couple in their late 50s. They will therefore need the inheritance money to last at least the next twenty-five years, if not more. Taking the view that some of this money is expected to be passed down to their heirs, their investment horizon is even longer. However, given their level of sensitivity to retirement costs, they should focus their investment plan on using this money to meet their own retirement needs, and not worry about passing it down.

Chapter 3 Executive Summary

Beatrix and Karl are not savvy investors and therefore will only be offered the most basic of securities -- money market instruments, bonds, stocks and mutual funds. Money market instruments give the lowest return but bear the least risk. They are short-term in nature. Bonds are riskier, but most types of bonds are relatively safe investments. Equity can be risky, but proper diversification can eliminate firm-specific risk. Mutual fund risk and returns depend on the fund.

The couple has a short time horizon, since they will need their inheritance money to help finance their retirement. They have a low risk tolerance, owing to their lack of investment sophistication. The portfolio chosen should reflect a low-risk orientation and short time horizon above all else.

Chapter 3 Investment Allocation

In order to make an investment allocation, it is worth outlining the risks and returns inherent in different types of investments. Being that Beatrix and Karl are not sophisticated investors, no esoteric securities will be utilized in this plan. They are unlikely to understand the risks inherent in derivatives, futures, or even options. The plan will therefore focus on money market securities, bonds, stocks and mutual funds.

The lowest risk form of security is the money market instruments. These are short-maturity securities with very low risk and correspondingly low interest rates. The typical use of money market instruments in a portfolio is to provide a means for the investor to negate the real loss of value caused by inflation, while maintaining near immediate access to the cash.

Bonds are issued by governments and corporations. They represent a debt holding in the firm. The bondholder essentially lends money to the company in exchange for payment (the interest). Bonds do not entail a portion of ownership in the company. The cash flows paid to bondholders are guaranteed by the issuer. Therefore, the risk inherent in bonds is relative to the risk of the issuer. The risk level of a bond can be determined by the issuer's credit rating. The higher the risk of the issuer, the higher the rate of return than the bond will pay.

Government bonds tend to be very safe. Bonds from Germany and other major Western countries are backed by those countries' assets. As a consequence, those bonds have virtually no risk. They pay low rates of interest, sometimes only slightly above the rate of inflation.

Corporate bonds are also backed by the assets of the issuer, in this case a corporation. Most corporations have higher degrees of risk than governments, and therefore their bonds pay more interest. High-grade corporate bonds can be a good investment, because they pay a higher rate than government bonds but are almost as safe. Bonds from high-risk companies are known as junk bonds.

Stocks are a different type of corporate investment altogether. They differ from bonds in a number of ways. Stocks represent an ownership (equity) stake in the company. Unlike bonds, stocks do not guarantee a fixed payment. Many companies do, however, pay a dividend, but that dividend must be declared every year. In the case of extreme crisis, a company is within its rights to cancel its dividend, as General Motors did a few years ago.

Like bonds, stocks have a risk-return relationship. That relationship is far more complex, however. The risk of a stock is typically measured as the correlation between the performance of the stock and the performance of the market as a whole. This correlation is known as the beta. It is believed that the market risk -- known as the systemic risk -- is inherent in all stocks. Modern portfolio theory therefore only addresses firm-specific risk.

The key to reducing the firm-specific risk associated with stocks is diversification. Modern portfolio theory holds that with sufficient diversification, firm-specific risk can be eliminated from the portfolio (McClure, 2009). Therefore, if Beatrix and Karl invest in one stock, they will face both market risk and firm-specific risk. If they have a diversified portfolio of stocks, they face only market risk.

In general, stocks are much riskier than bonds. Historic returns on equities are much higher than historic returns on stocks in order to compensate for…[continue]

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