Susan Is Young, Earns a Great Income

¶ … Susan is young, earns a great income and has no dependents. The portfolio she has inherited can be used as a good starting point for a retirement portfolio. In her case, the funds will not be needed until retirement, setting the time horizon for investing at least 20-30 years in the future. Susan also does not benefit from having income from this portfolio -- she does not need the money. Thus, the portfolio is not presently constructed according to Susan's needs. It is designed for the needs of her now-deceased father and needs to be reinvested in line with Susan's time horizon, cash flow requirements, and tax requirements.

The asset allocation of this portfolio is as follows. Bonds are 46.78%, stocks are 28.67% and mutual funds are 11.78%. The mutual funds appear to be mostly geared towards income securities. This asset allocation is not consistent with the long-term, tax-reduction objectives that Susan should have. There is too much income ($33,400), which gives off too much tax, and there is not enough long-term growth. She will be paying 40% tax on that income, yet unlike her father she does not need the income to live. Therefore, Susan should aim to eliminate that income. She will want that reinvested into the portfolio and then it will be taxed later when she starts to take money out of that portfolio. It is expected that her tax rate at this later date, in retirement, will be lower than her current tax rate as a high income earner.

c. The optimal security for Susan's needs would be comprised entirely of equities. The portfolio should be diversified, so if adequate diversification cannot be attained with $338,000, then equity mutual funds should be used to ensure sufficient diversification. However, it is likely that adequate diversification can be obtained with equities. The only compelling reason to invest in a mutual fund is to use that part of the portfolio to hold low-risk equities, where the dividends from those securities are reinvested in the fund and therefore not taxed as distributions by Susan. Susan should also put the entire portfolio in a tax-sheltered retirement fund. This portfolio would have a relatively high risk profile and be weighted towards equities with good long-term growth prospects, such that most of the gains in the portfolio are in the form of capital gains. This would maximize the long-run return of the portfolio while minimizing the tax burdens associated with the portfolio. With her high tax rate and ample income, there is no need for Susan to earn dividends or bond interest with this portfolio, as she will pay a lower tax rate in retirement on withdrawals from the portfolio than she will now while she occupies a high tax bracket.

d. As noted, an appropriate portfolio for Susan would be 100% equities. The equities currently in her portfolio are not appropriate, as they have high dividend yields, and with low betas are not likely to be strong growth stocks going forward.

e. Essentially, all of the assets in this portfolio need to be divested and replaced with good growth stocks. The purchases should be gradual, when opportunities present themselves. There is no point to buying at the peak of the market, even when long-term growth is the objective. The portfolio can be fully diversified with as few as 10 stocks, depending on how well they are chosen. Somewhere between 10-15 stocks would give sufficient diversification while minimizing transaction fees incurred during the restructuring of the portfolio. More securities would incur more transaction fees but would not necessarily add to diversification. Susan's new portfolio should have stocks with different risk levels, maybe aiming for a beta between 1.0 and 1.1 because of the time frame and her lack of need for the money in the short run, and should be from a range of industries and there should also be some international either direct (ADRs) or indirect (from exposure, i.e. through multinationals). Susan may wish to consider setting aside an amount ($50-100K) in case of layoff from her current position and keep this in fixed income, although there will be a tax consequence of building in this safeguard.

Excel with Spreadsheets

a. The beta for HP is 1.08 and the beta for IBM is 0.66. The risk free rate of return (2-year Treasury) is 0.26% (Yahoo! Finance, 2012). Using a 5% return is unrealistic as the risk free rate, given that even 30-year Treasuries only pay 2.74% as a yield (Ibid).