QUIZ #5

What is the stated goal of a target-date mutual fund?

- To relieve administrative duties that would be required under the "100 minus your age" method. - To reduce stock market risk as an investor reaches retirement.

What is the objective of Monte Carlo simulation?

-To study and imitate a real-life scenario involving randomness. -To run many random trials and use the results to develop an understanding of the range of likely outcomes. -To illustrate possible outcomes of a series of random events.

Consider an investor with a portfolio of $500,000 allocated 70% stocks and 30% bonds. That is, she invests $350,000 in stocks and $150,000 in bonds. One year later, the value of the stock in her portfolio has risen to $395,000 and the bonds are valued at $165,000. Calculate the annual rate of return for both stocks and bonds, rounding to the nearest whole number and then calculate the weighted average rate of return. The weighted average rate of return is approximately:

12%

weighted avg rate of return

= ws x rs + wb x rb --> to get r do new/old -1 *If investor wants greater retur, increasea llocation to risky assets and reduce allocations to safe assets (TIPS). To reduce risk do the opposite!

Explain asset allocation and discuss the conventional wisdom about asset allocation over an investor's lifetime.

Asset allocation is the practice of spreading your assets across multiple asset classes, such as stocks, bonds, cash, real estate, and precious metals --> mitigates risk by systematically reducing exposure to stocks. Conventional wisdom tells investors to change their asset allocation to be more conservative as they age (ex. invest 100-age percent of wealth in risky assets). While this asset allocation reduces your exposure to stocks as you age, it does not reduce the risk of losing money in the stock market, nor does it guarantee that you will have more wealth at retirement than investing in TIPS.

Explain the general idea behind a Monte Carlo simulation and how it models the randomness in a series of events. Discuss how we developed simulated stock returns using this technique.

Is a statistical and computational technique involving a series of random events to make predictions. Can be used to illustrate the effect of the sequence of stock returns, which determines the amount of final wealth at the end of an investor's holding period. In excel, use RAND() function to generate simulated stock returns. These will follow the historic distrib of real stock returns, which means they will be clustered around the mean historical return & will be distributed randomly around that value based on the historical SD of annual returns. return = mean + Z*sd --> calculate Z based on probability value in the range (0,1) with NORM.S.INV() function. Use the randomly generated rates of return to find the evolution of an investor's wealth over time.

Which of the following reduces the probability of experiencing a loss on a stock investment in any one year?

Not investing in stocks.

For asset allocation to work properly, you would want your investments to be

Not perfectly correlated

Why is it so hard to make predictions about the distant future?

Predictions we make about the distant future depend on the predictions we make in the near future.

How often should an investor rebalance his asset allocation?

Rebalancing is the process of selling or buying within specific asset classes to return to your target asset allocation. -Quarterly, if the transaction costs are sufficiently small -At least annually

Explain giving an example how the sequence of returns could adversely affect your standard of living.

Seq=the order in which the rates of return are achieved. This doesn't change for investors who are fully invested for entire time period. It matters when making withdrawals or contributions. The 4% withdrawal rule sets a spending rate of 4% of your wealth, adjust annually with inflation. Standard of living depends on financial wealth, so if your investment does poorly, you will arrive at retirement with less wealth than anticipated. Ex. = Having several losses in first several years of retirement, quickly using up retirement wealth, running out of assets in mid 70s = before they die.

What does the conventional wisdom tell investors about the risk of investing in stocks for the long run?

Stocks are not risky in the long run because stocks have never experienced a loss over a 20-year time horizon.

Explain the conventional wisdom about investing in stocks for the long run. What is the evidence that supports this conventional wisdom and what is incorrect about the conventional interpretation of this evidence?

The conventional wisdom is that stocks are a safe investment for the long run (reduces risk). Makes the case that over the long run investors who hold stocks will be rewarded by a risk premium (earn higher rate of return by taking on risk). --> FALSE! Despite historical record, nothing guarantees that this will hold true. Monte Carlo simulation illustrates the distribution of future stock returns. The distribution of possible outcomes becomes more spread out with time. While the probability of loss might decrease with a longer time horizon, the magnitude in dollars) of the potential losses increases with time.

Which statement is true about the risk of investment in stocks with respect to investment time horizon?

The risk of investing in stocks increases as you lengthen the investment time horizon.

Define the concept of value at risk and give a numerical example to explain what it measures.

The value at risk provides a single number to describe how many dollars your investment portfolio might lose due to a large-magnitude bad event (2 SDs below mean return) in the stock market. Due to the sequence of returns risk, it is still possible that several years of bad investment returns right near retirement could unravel a lifetime of good saving habits and investment results. Equation: A = ws x rs (A is amount of invested assets, ws is weight of assets held in stocks, r is rate of return on stocks from bad event).....Ex: 25 y/o investor w $10000 in assets 75% allocated to stocks, expect stocks lose 31% of their value, his loss would be about = 10000 x 0.75 x -0.31 = $2325

What is a target-date mutual fund? How does it attempt to help investors change their asset allocation over time? In what ways are target-date mutual funds more or less risky than investors expect?

They reduce allocation to stocks in a systematic way so as to reduce the investor's market exposure by the targeted retirement date. When evaluating a target-date fund, you need to understand its glide path, or how the fund's asset allocation is supposed to change as you age. Because the glide path changes the fund's asset allocation, the fund may end up selling at lows and buying at highs. Investors are then less likely to recoup their losses than if they held the same investments outside of a target-date fund and waited to sell until the market improved. You have the power to adjust your own risk by investing in a fund outside your own retirement timeline. If you want more potential for gains, invest in a fund with a target date further out; for less risk, invest in a fund with a closer target date.

What are the main ideas and benefits of upside investing? How does it help us evaluate the risk-reward tradeoff of investing in risky assets?

Upside investing is an investment strategy that treats stock market investments like casino gambling, is a strategy to help you achieve some of the upside gains of investing in risky assets without the risk of a decline in living standard due to poor investment results. Consumption is planned out of safe assets only, and not out of risky assets. A living standard floor below which your future consumption cannot fall is calculated based on labor income, social security benefits, and investments in safe assets. As you age, you convert risky assets to safe assets, thus allowing these assets to be used for consumption. If you experience gains in stock market investments, this will result in a rising standard of living. The amount of wealth you decide to invest in risky assets should be based on how much you need to allocate to safe assets to secure your minimum standard of living.

Explain why stocks are risky even in the long run. Discuss the results of the Monte Carlo simulation presented in the module and in class.

When looking at the confidence intervals for future investment returns in the module, the risk of stock market nvestment grows with the time horizon. Long time horizon does not diversify stock market risk, it amplifies it! Conventional wisdom is false. MC module- One random trial is hardly indicative of what an individual investor should expect for future wealth. The power of the MC simulation technique is being able to run a lg. number of trials and make observations about the distrib of the outcomes. The amount of the ending wealth depends on the returns earned in the earlier years as well as the sequence of returns. Majority of the trials shows ending stock market wealth exceeding TIPS benchmark (fell short of benchmark less than 1/5 of the time).