Reference no: EM13919269
An investment advisor at Shore Financial Services wants to develop a model that can be used to allocate investment funds among four alternatives: stocks, bonds, mutual funds, and cash. For the coming investment period, the company developed estimates of the an- nual rate of return and the associated risk for each alternative. Risk is measured using an index between 0 and 1, with higher risk values denoting more volatility and thus more uncertainty.
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Investment
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Annual Rate of Return (%)
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Risk
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Stocks
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10
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0.8
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Bonds
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3
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0.2
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Mutual funds
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4
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0.3
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Cash
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1
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0.0
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Because cash is held in a money market fund, the annual return is lower, but it carries essentially no risk. The objective is to determine the portion of funds allocated to each in- vestment alternative in order to maximize the total annual return for the portfolio subject to the risk level the client is willing to tolerate.
Total risk is the sum of the risk for all investment alternatives. For instance, if 40% of a client's funds are invested in stocks, 30% in bonds, 20% in mutual funds, and 10% in cash, the total risk for the portfolio would be 0.40(0.8) + 0.30(0.2) + 0.20(0.3) + 0.10(0.0) = 0.44. An investment advisor will meet with each client to discuss the client's investment objectives and to determine a maximum total risk value for the client. A maximum total risk value of less than 0.3 would be assigned to a conservative investor; a maximum total risk value of between 0.3 and 0.5 would be assigned to a moderate tolerance to risk; and a max- imum total risk value greater than 0.5 would be assigned to a more aggressive investor.
Shore Financial Services specified additional guidelines that must be applied to all clients. The guidelines are as follows:
- No more than 75% of the total investment may be in stocks.
- The amount invested in mutual funds must be at least as much as invested in bonds.
- The amount of cash must be at least 10%, but no more than 30% of the total invest- ment funds.
a. Suppose the maximum risk value for a particular client is 0.4. What is the optimal allocation of investment funds among stocks, bonds, mutual funds, and cash? What is the annual rate of return and the total risk for the optimal portfolio?
b. Suppose the maximum risk value for a more conservative client is 0.18. What is the optimal allocation of investment funds for this client? What is the annual rate of return and the total risk for the optimal portfolio?
c. Another more aggressive client has a maximum risk value of 0.7. What is the optimal allocation of investment funds for this client? What is the annual rate of return and the total risk for the optimal portfolio?
d. Refer to the solution for the more aggressive client in part (c). Would this client be in- terested in having the investment advisor increase the maximum percentage allowed in stocks or decrease the requirement that the amount of cash must be at least 10% of the funds invested? Explain.
e. What is the advantage of defining the decision variables as is done in this model rather than stating the amount to be invested and expressing the decision variables directly in dollar amounts?
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