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CHAPTER 20
FINANCIAL PLANNING AND INVESTING IN AN EFFICIENT MARKET CONTEXT
This brief chapter provides one last opportunity to review major concepts. These include:
1. Investing is a means to achieve financial objectives. Investing is not an end unto
itself.
2. Investment returns are uncertain; investors must bear risk.
3. Asset-specific risk is reduced through the construction of well diversified
portfolios. Other sources of risk may be managed but not erased.
4. The fundamental analytic process used to select assets progresses from the general to
the specific. The process starts with the economic and regulatory environment and
progresses through market sectors to industries to specific firms and their securities.
5. Outperforming the market on a risk-adjusted basis over an extended period of
time is difficult and rare. This conclusion emanates from the efficient market hypothesis.
Even if the efficient market hypothesis (EMH) does not hold for all periods and all
Teaching Guides for the Financial Advisor’s Case: Goals and Portfolio Construction
This case may be used to tie the course together by considering how to construct a
portfolio with consideration for tax implications and the required amount of supervision.
The investor, Vanessa Avoletta, is a successful writer who earns $100,000 to $150,000 a
year. She is divorced and has one child who is entering high school. Ms. Avoletta is
concerned with saving for retirement and reducing the amount of income taxes she pays.
She does not want to write as prolifically in the future. Thus there are at least two implied
financial goals: education for the child and the need for supplemental income once she
reduces her writing. Funds for the child's college will be required in approximately four
years, and the funds will be needed for four years. The time dimension of the other goal is
indefinite. An additional question raised in the case is who will manage the portfolio since
Ms. Avoletta has limited knowledge concerning investments.
Four possible strategies are suggested (which are not mutually exclusive and do not
exhaust all possible strategies) and four questions concerning each strategy are raised. The
following teaching guides consider each strategy and the four questions individually.
1. The IRA with a commercial bank:
a. Ms. Avoletta would own an obligation of the bank (i.e., a variable rate CD).
b. There would be no current federal income tax on the interest earned on the account, and
c. Ms. Avoletta would have control of the CD but would have no control over how the bank
d. Once the account was opened, it would require a minimum amount of supervision. The
2. The self-directed Keogh account:
a. The Keogh account, like the IRA, is a retirement plan. A self-directed plan with a
brokerage firm permits the investor to acquire a variety of financial assets. While many
b. Funds deposited in the Keogh account are excluded from current federal income
taxation, and any income earned by the assets is also not currently taxed. Federal income
taxes are deferred until the funds are withdrawn from the account. The big differences
c. If an investor sets up a self-directed Keogh account, the choice of the assets to include
d. If the individual makes the investment decisions, this type of account will require
3. Keogh account with a mutual fund:
a. With this strategy the investor owns shares in the mutual fund which, in turn, owns the
specific securities. The investor could have more than one mutual fund, but each fund owns
the specific securities in its portfolio.
b. The tax implications are the same for all Keogh accounts: the investor may deduct
c. Since the investor owns shares in the mutual fund, the investor has control over those
d. The amount of required supervision is small, since the investor is not making the security
selections. The fund will send the investor timely statements which relieve the investor of
4. Personal account with a brokerage firm:
a. The investor may select from a spectrum of assets through a broker including stocks,
b. Funds invested through a brokerage account offer some tax advantages. Currently
dividend income is taxed up to 15 percent. Interest on municipal and state bonds is exempt
from federal taxation. Realized capital gains would be subject to income and capital gains
d. Such an account will require supervision by the investor. However, if the investor does
not actively trade the securities and purchases stocks and holds them for their long-term
potential, the amount of supervision should not become burdensome.
Possible courses of action include:
Ms. Avoletta should open a retirement account to shelter current income from taxation.
Since she is eligible for a Keogh account, it makes more sense to open a Keogh since more
funds may be tax sheltered. Since Ms. Avoletta is not knowledgeable concerning
Ms. Avoletta should probably also open the brokerage account and acquire systematically
conservative growth stocks (or invest in a growth mutual fund). While the stocks may not
generate significant income, they should generate capital gains over a period of years.
Stocks will also diversify the overall portfolio, which would then include the Keogh and/or
the IRA and the savings accounts. The growth stocks could also help finance the child's
education with will require funding in five to eight years.
1.Ms. Avoletta has a record of poor health. This implies a more conservative strategy is
required. Ms. Avoletta will need more liquid assets to meet emergencies. Any securities
2. Ms. Avoletta desires to start taking life easier. This goal will reduce income and argue for
securities that generate more income and less growth potential. However, if Ms. Avoletta
does take a teaching position, her income may become more certain. You need to know not
3. Ms. Avoletta has expensive tastes and finds saving to be difficult. This strongly argues
for removing discretionary power and reducing the decision making required of the
investor. Once income is received, it is easily spent. You should explore means to divert
income before it is received. For example, IRA or Keogh accounts with a commercial bank
may be desirable as the bank can periodically withdraw funds from other accounts to
finance the retirement account. If Ms. Avoletta buys securities such as stock (or mutual
Teaching guides for the Financial Advisor’s Case: The Bruckner’s Asset Allocation
This case may be used to tie several topics that appear throughout the text: investment
returns, diversification, asset allocation, and financial planning. The setting is built around
a two-income family, one of whom (Erik) is self employed. The other (Senta) is employed
outside the home and that employment covers medical insurance and a 401(k) plan.
1. The Bruckner’s have investable assets of $240,000. $40,000 is in the 401(k), and
$50,000 must be in a safe, liquid investment. The remaining $150,000 is available to be
invested in a variety of assets.
The specified asset allocation is
Corporate bonds $40,000/$240,000 = 17%
To achieve this allocation, the funds in the company stock in the 401(k) plan must be
2. The expected returns are
large company stock 10%
If these returns are used for ten years, the funds in each account are as follows:
Large-cap stocks:
Small-cap stocks:
Corporate bonds:
Treasury bills:
The total in the account is
3. After ten years, the asset allocation is
Corporate bonds $71,634/$566,300 = 12.6%
The asset allocation is now off and adjustments should be made. The small cap stocks
should be reduced and the funds transferred to the bills and bonds. The large cap stocks are
reasonably close to the initial allocation.
4. This question raises the issue of how much would be in the account if the returns are not
achieved. It asks the student to repeat the question 2 but assume much lower returns on the
stocks. (1.4% and 3.2% are the actual returns experienced during 1965 through 1974.)
If these returns are used for ten years, the funds in each account are as follows:
Large-cap stocks:
Small-cap stocks:
Corporate bonds:
Treasury bills:
The total in all the accounts is
5. Using the original amounts and the returns from question 2, after thirty years each
account will be worth:
Large-cap stocks:
Small-cap stocks:
Corporate bonds:
Treasury bills:
6. If the rate of inflation is 3 percent, goods that currently cost $100 will cost $243 after
thirty years. The Bruckners will need $243,000 annually at retirement to maintain the
7. If they earn 7 percent on their portfolio of $4,156,480, they can receive an annuity of
$456,359 for fifteen years. The annuity payments are less than the estimated $243,000 that
1. They earn the rates of return given in Question 2 and not the ones in Question 4
2. They earn 7 percent after retirement
3. They financed their children’s education from another source
4. Inflation was only 3 percent and did not continue after they retire
5. Life expectancy is 15 years
6. Their situation does not change (e.g., health).
8. There are, of course, many possible courses of action. Certainly changing the
composition of the 401(k) plan is desirable. Given the long-term nature of the Bruckner’s
