Asset Allocation: The Muellers Case

Peter and Andrea Mueller, U.S. residents, are reviewing their financial plan. The Mueller both age 53, have one daughter, age 18. With their combined aftertax salaries totaling $100,000 a year, they are able to meet their living expenses and save $25,000 after tax annually. They expect little change in either their incomes or expenses on an inflation-adjusted basis other than the addition of their daughter's college expenses. Their only long-term financial goal is to provide for themselves and for their daughter's education. The Muellers both wish to retire in ten years.

Their daughter, a talented musician, is now entering an exclusive fiveyear college program. This program requires a $50,000 contribution, payable now, to the college's endowment fund. Thereafter, her tuition and living expenses, to be paid entirely by the Mueller are estimated at $40,000 annually.

The Mueller's personal investments total $600,000, and they plan to continue to manage the portfolio themselves. They prefer "conservative growth investments with "minimum volatility." Onethird of their portfolio is in the stock of Andrea's employer, a public traded technology firm with a highly uncertain future. The shares have a very lowcost basis for tax purposes. The Muellers, currently taxed at 30 percent on income and 20 percent on net realized capital gains, have accumulated losses from past unsuccessful investments that can be used to fully offset $100,000 of future realized gains.

In ten years, Peter will receive a distribution from a family trust. His portion is now $1M and is expected to grow prior to the distribution. Peter receives no income from the trust and has no influence over, or responsibility for, its management. The Muellers know that these funds will change their financial situation materially but have excluded the trust from their financial planning.

A. Construct the objectives and constraints portion of an investment policy statement for the Muellers, addressing each of the following:

Return objective

Risk tolerance

Time horizon

Liquidity

Taxes,

Unique circumstances

B. Recommend and justify your suggested allocation of their capital that is consistent with the investment policy statement in A. It is recommended that three sets of asset allocation be developed - the first 5-years, the next 5 years, and the afterwards.

I. Policy Statement

Investment Objectives

Return Objectives

Capital Appreciation -> Need for some growth of assets over time

(Justify)

Capital preservation -> Preserve their financial position on an inflation-adjusted basis

(Justify)

Distribution of $1M is excluded from this plan, but it will be an important factor that will substantially increase their capital base and dramatically alter the return objectives.

Risk Tolerance

Muellers' Preference: Minimum volatility

Large capital loss from previous investments;

Relatively large holdings of their technology company with high future uncertainty (need to fix this!)

Their need for continuing cash outflow to meet their daughter's college expenses

Your Suggested Risk Preference:

(Justify)

Constraints(Feel free to complete by adding statements or justifications))

Time Horizon- LT, but multi-stage time horizon

1^st5 yrs - Some assets, negative cash flows

2^nd5 yrs -

Afterward -

Liquidity

$50,000 college contribution (low cost stocks)

$15,000-20,000 College expenses

Taxes

Capital gains preferred, but low-cost stocks concern, but $100,000 loss carry-forward

Unique situation

Technology firm stock - high uncertainty reduces risk-taking ability. Trust fund distribution

II. Asset Allocation Decisions

SUGGESTED ASSET ALLOCATION: 1^st5 Year

Range (%)

Current Target (%)

Cash or Money Market

US Fixed Income

(ConsiderMunicipal Bonds)

Foreign Fixed Income

US Stocks - Large caps

US Stocks - Small caps

Foreign Stocks

Real Estate

Other

Justifying Comments:

SUGGESTED ASSET ALLOCATION: 2^nd5 Year

Range (%)

Current Target (%)

Cash or Money Market

US Fixed Income

(ConsiderMunicipal Bonds)

Foreign Fixed Income

US Stocks - Large caps

US Stocks - Small caps

Foreign Stocks

Real Estate

Other

Justifying Comments:

SUGGESTED ASSET ALLOCATION: After Year 10

Range (%)

Current Target (%)

Cash or Money Market

US Fixed Income

(ConsiderMunicipal Bonds)

Foreign Fixed Income

US Stocks - Large caps

US Stocks - Small caps

Foreign Stocks

Real Estate

Other

Justifying Comments: