PDA

View Full Version : Hypothetical Investment Problem

jdoe
08-10-2005, 11:36 PM
Lets say you have \$150 a week to invest over 5 years with a goal of reaching \$50,000.00

I estimate that you would need to get an annual return &gt; 9.59% (please correct me if i am wrong)

1. You want this investment to be able to go on AUTOPILOT for 5 years.

2. Since this investment would be weekly, you would want to be able to invest with very small transaction costs.

3. Earning a higher rate of return would be nice but not necessary. For this hypothetical investment problem, if the goal is reached before the 5 years are up, the funds would be converted into a CD for the exact time remaining.

What do you invest in and why?

Sniper
08-11-2005, 08:58 AM
The answer will depend on the why 50K is the 5 year goal, what the consequences are for not reaching your goal, and your risk tolerance.

There is no automatic guaranteed 9%+ return.

The easiest way to put this type of investment on autopilot would be to invest in a No transaction fee mutual fund with monthly automatic investments; and automatic weekly transfers from your bank account to your brokerage account.

Your answers to the questions I listed would determine which type of fund would be the most appropriate.

Also, if you were achieving 9%+, why would you swich the funds to a CD, and forgo the potentially additional income?

Dan Mezick
08-11-2005, 10:46 AM
Figuring out how to make 39K into 50K saving \$150 a week @ 9.59% is the easy part.

Knowing how much risk you accept and assume to obtain the target return is the much harder problem.

Figure out your risk tolerance (how much of the total you are willing to put at risk of 100% loss) to get the 9.59%.

Studying the measure called Sharpe Ratio (http://www.moneychimp.com/articles/risk/sharpe_ratio.htm) may be helpful to you at this stage in your process. See also: Efficient Frontier (http://www.moneychimp.com/articles/risk/efficient_frontier.htm)

After you know how much 'heat' you are willing to take, you can select from a set of suitable instruments that match the risk/reward ratio range you are OK with.

See also this great link for your next step. This has a nice little worksheet for asset allocation using risk as an input:
Sharpe Ratio and Portfolio Composition (http://www.moneychimp.com/articles/risk/portfolio.htm)

jdoe
08-11-2005, 12:09 PM
[ QUOTE ]
The answer will depend on the why 50K is the 5 year goal, what the consequences are for not reaching your goal, and your risk tolerance.

There is no automatic guaranteed 9%+ return.

The easiest way to put this type of investment on autopilot would be to invest in a No transaction fee mutual fund with monthly automatic investments; and automatic weekly transfers from your bank account to your brokerage account.

Your answers to the questions I listed would determine which type of fund would be the most appropriate.

Also, if you were achieving 9%+, why would you swich the funds to a CD, and forgo the potentially additional income?

[/ QUOTE ]

For the sake of this hypothetical, any risk over 50K is useless, and earning less then 50K is catostrophic.

Use this silly example: You know that your daughter will be kidnapped in 5 years. The ransom will be 50K for her safe return. You only have \$150 per week and must invest it to grow to \$50K at the end of 5 years. IE very bad if we miss and every reason to lock up the 50K if we hit that benchmark early.

I know this is a silly hypothetical, but given these conditions, how would you invest the \$150 a week to gain the maximum chance of sucess?

jdoe

FishHooks
08-11-2005, 12:41 PM
I would take out a loan, heh just pulling your chain on the hypothetical question.

08-11-2005, 02:29 PM
Earn more money and save \$200 instead of \$150.

Failing that, do the automatic investment into an index fund. If the deadline approaches and you are not on track to hit the target, switch to riskier assets such as emerging markets stocks and bonds. If you make money early, switch to less risky assets.

Sniper
08-11-2005, 07:38 PM
[ QUOTE ]
and earning less then 50K is catostrophic.

[/ QUOTE ]

If earning the 50K in 5 years was that critical, you should be actively managing the \$\$\$, not put it on autopilot, and in that case hitting your goal should be fairly easy.

eggzz
08-11-2005, 09:40 PM
Assuming this is not your only investment vehicle, and also assuming that if you don't hit your goal, it won't be the end of the world this is my recommendation--EDIT--I just read your ransom post, however, I still start off on this route---END EDIT: Buy stock in a great blue chip company through its Dividend Reinvestment Program.

I am in ExxonMobils and the transaction costs are nil. Here are the stock prices over the last five years:

7/00 - \$79
7/01 - \$88 (11%)
7/02 - \$41 (stock split - return 0% for year)
7/03 - \$37 ( -9%)
7/04 - \$45 (12%)
7/05 - \$61 (14%)

Ok, this is only 5.6% average return over five years, but what about the consistent dividends that the stock pays? From what I can tell about the historical dividend I think that should add the equivalent of at least 2% to the stock appreciation raising us to 7.5%? I don't know how to figure that out.

I guess the two year span of a negative return didn't help this post too much, but this was during the economic downturn, and many blue chips struggled during this same time. I think 10% (plus dividend) really is the norm for this strong company, and I'm happy to stick with them, and keep plugging away whether the stock is up or down.

I think you would have a good shot at getting your 9.5% plus with this company over the next five years, with relatively minimal risk.

Sniper
08-11-2005, 10:33 PM
[ QUOTE ]
Buy stock in a great blue chip company through its Dividend Reinvestment Program.

[/ QUOTE ]

Blindly putting all your faith in 1 stocks, would be a high risk way to go.

eggzz
08-12-2005, 08:58 PM
Sniper did you not read the first sentence of my post?

[ QUOTE ]
Assuming this is not your only investment vehicle,

[/ QUOTE ]

Sniper
08-12-2005, 10:51 PM
so, you are saying that your post had nothing to do with the hypothetical question posed by jdoe?

eggzz
08-13-2005, 01:54 PM
Of course it did. I just prefaced my comments on the assumption that the investor was already well diversified, and it seemed to me that his hypothetical scenario was either a bet, or a challenge from a friend of his to return the required equity within 5 years, and if he failed, well so be it, he lost the bet.

Thats why I chose the route of XOM DRIP. I felt it had a great chance of achieving his goal, the brokerage/commission fees are zero, and if he did fail, he'd still have a nice chunk of a solid blue chip stock company to add to his portfolio.

However, when he added the ransom part, and made it more of a life or death challenge, this in turn made my suggestion more of a risk.

However, I still stand by my post.