FIN 3210 Module 8 Final Paper: An Investment Policy Statement for a Trenton Household Example

Eighteen Years to Retirement: An Investment Policy Statement for the Okafor Household

Student Name

B.S.B.A. in Finance, Thomas Edison State University

FIN-3210: Security Analysis and Portfolio Management

Mentor Name

Month Day, Year

Eighteen Years to Retirement: An Investment Policy Statement for the Okafor Household

1. The Investment Process

The CFA Institute's framework, presented by Bodie et al. (2017), divides portfolio management into three steps: planning, which identifies objectives and constraints and produces an investment policy statement; execution, which selects assets and builds the portfolio; and feedback, which monitors results and rebalances. The policy statement comes first because it records decisions made calmly, so they can guide choices when markets are not calm.

2. Client Profile

3. Return Objective

To reach $1.6 million in 18 years from $310,000, the couple must save and earn enough. At a 6 percent average annual return, today's $310,000 grows to about $884,800, leaving about $715,200 to come from new saving. Saving at the end of each year, that requires about $23,140 a year, roughly 14 percent of their income, a reachable figure given that both employers' plans accept contributions and the librarian's employer matches part of hers. The required return is therefore 6 percent a year, nominal. A higher assumed return would lower the required saving but would require more risk; a lower one would require saving that crowds out the college goal.

The table shows how sensitive the goal is to the return the portfolio earns, with saving held at about $23,140 a year.

A single percentage point of return changes the result by roughly $200,000 in either direction. If returns run near 5 percent, the couple would need to save about 16 percent of income rather than 14, or work two more years; the policy therefore commits them to reviewing the savings rate, not only the portfolio, at each annual review.

4. Risk Tolerance

Risk tolerance has two sides. Ability to bear risk is high: the couple has 18 years until retirement, two stable public and union jobs and two pensions that will cover a large share of basic retirement spending, all of which act like a bond-like asset in their total wealth. Willingness to bear risk is moderate: on a risk questionnaire they scored as moderate, and in the 2022 market decline they reduced contributions for several months before resuming. The policy reconciles the two by setting risk somewhat below what their ability alone would allow, at a level they are likely to hold through a downturn. Frequent traders among individual investors earned less, as Barber and Odean (2000) showed, so a policy the couple can stick with is worth more than one that is theoretically optimal but abandoned in a bad year.

Behavioral finance explains why willingness deserves weight even when ability is high. Investors tend to feel losses more sharply than equal gains, and those who sell after a decline often lock in the loss and miss the recovery. The couple's own record in 2022 shows that tendency. An allocation they can hold through a 25 percent stock decline is worth more than a more aggressive one they would abandon, so the policy sets the stock weight where their past behavior suggests they will stay invested.

5. Constraints

6. Strategic Asset Allocation

The 65 percent stock allocation reflects the high ability to bear risk and the pensions' bond-like role, moderated by the couple's willingness. Assuming long-run returns of 7.5 percent on stocks and 4 percent on bonds, the couple's mix earns roughly 6.3 percent, a little above their 6 percent need, with volatility around 11 percent. The mix follows the insight of Markowitz (1952): stocks provide growth, bonds and TIPS reduce volatility and protect against inflation and international stocks diversify away from U.S. and local economic risk. Low-cost index funds are used throughout, since fees reduce returns with certainty while active management adds returns only uncertainly (Carhart, 1997).

Index funds are chosen for every asset class. Evidence on actively managed funds, reviewed in Module 6, shows that most fail to beat their benchmarks after fees over long periods, and the fee difference compounds: on a portfolio growing toward $1.6 million, an extra percentage point of annual cost would cost about $200,000 by retirement, as the return table above shows. For a household without the time or expertise to select managers, low-cost index funds are the efficient choice.

7. Implementation, Rebalancing and Review

Contributions will be directed to whichever asset class is furthest below its target. If any class moves outside its range, the portfolio will be rebalanced back to target, using new contributions first and trades inside tax-deferred accounts second, to avoid taxable gains. Starting at age 55, the stock target will fall by one percentage point a year until retirement, reaching 55 percent at 65, as the horizon shortens. The policy will be reviewed each January and after any major change: a job change, a pension decision, an inheritance or the end of college costs.

An example shows how the range rule works. If a strong year lifts U.S. stocks to 52 percent, above the 50 percent ceiling, the next six months of contributions go entirely to bonds and international stocks; if that does not bring stocks back inside the range, the couple sells stock fund shares inside the 401(k), where the sale has no tax cost, and buys the bond fund. Rebalancing in this way sells assets that have risen and buys those that have lagged, which enforces discipline at exactly the moments it is hardest.

8. Monitoring Performance

Performance will be judged against a blended benchmark made of index returns in the target weights, so the couple can see whether any shortfall comes from the market or from their own choices. Risk-adjusted measures from Module 6 apply here: the Sharpe ratio is the right measure because this portfolio is the couple's main investment holding.

The couple will receive a one-page summary each quarter showing the allocation against its targets and ranges, and a fuller report each year comparing the portfolio's return with the blended benchmark, the required return and the savings plan. The annual report will also check the policy's assumptions, such as expected returns and the pensions' projected benefits, so that the statement stays current as the couple's circumstances change.

9. Conclusion

The policy turns the couple's goal into a required return, sets an allocation they can hold through market swings and fixes the rules for saving, rebalancing and review in advance. Its main contribution is discipline: the decisions that matter most were made here, not in the middle of a market decline.

References

Barber, B. M., & Odean, T. (2000). Trading is hazardous to your wealth: The common stock investment performance of individual investors. Journal of Finance, 55(2), 773-806. https://doi.org/10.1111/0022-1082.00226

Bodie, Z., Kane, A., & Marcus, A. J. (2017). Essentials of investments (10th ed.). McGraw-Hill Education.

Carhart, M. M. (1997). On persistence in mutual fund performance. Journal of Finance, 52(1), 57-82. https://doi.org/10.1111/j.1540-6261.1997.tb03808.x

Markowitz, H. (1952). Portfolio selection. Journal of Finance, 7(1), 77-91. https://doi.org/10.1111/j.1540-6261.1952.tb01525.x