Ok so the question goes that the client will require 60k after tax to meet her living expenses and another 30k to support her son for a total after tax return of 90k. Expected inflation is 3%
Her portfolio value is 2 mil which gives us an after tax return of 4.5%
The solution given states the 4.5% is the real required rate of return and to arrive at nominal we add the inflation rate.
I’m familiar with the formula of deriving nominal returns from real return but am just a bit confused as to how do we know if the required return is real or nominal or is it simply a case of when a case like the above is given required returns are always in real terms and must be adjusted to get nominal.
As follow up to the above on page 202 of the official CFA text in one of the case studies the required return is 50k on a portfolio value of 1.12 million which gives us a required real return of 4.5%
The portfolio generates a return of 82,500 or 7.4%. This 7.4% is considered a nominal rate and inflation of 3% is reduced to get an actual return of 4.4%
Could anyone explain why is the portfolio return considered a nominal figure whereas the required return is considered a real figure.
ZThat question didnt ask what the returns would be. If i recall, It asked if he would have enough to spend based on the return he was getting. You can find that out using nominal numbers or real numbers.
Unfortunately, the vignette does not explicitly say that she wants her portfolio return to include inflation (as by saying that she wants to maintain the real value of the portfolio, or maintain purchasing power, or the like). It should have.
The portion of the return that covers actual shortfall (e.g., living expenses not covered by salary, pension, or whatever) is a real return. If the return has to include an inflation component as well, it’s a nominal return.
Rest assured that on the real exam they make it clear whether the return calculation is real or nominal.
Magician (as usual) has explained everything. I think I would take the liberty to summarize as follows for a ready reckoner:
It is perfectly alright if the reqd. return is expressed as Nominal Return= Real+ Inflation PROVIDED it talks SPECIFICALLY about a single period. In case it is mentioned about multi horizon it has to be multiplicative.
If the portfolio has to retain its real value then the Inflation portion is retained with the portfolio. Now this becomes a little confusing… but think of it as what is being taken out of the Investment base. Since the portfolio becomes ‘poorer’ because of the income component as cash outflow, hence now the income is also roped in along with capital appreciation and topped by inflation. Long discourse given, because some investors may have ‘wasting’ portfolio ( very old or terminally ill patient with little or no bequest). Such portfolios will not require any treatment towards inflation
Pre Tax and Post Tax- to which and how to apply inflation. Simple solution exists. If the income component is only a portion of the desired return ( i.e. < 100%), then it is evident that the inflation portion has to be with the Investment base. So in such case find the pre tax return first applying the formula AT Return/(1-T%) and then add inflation. If the income component is the desired return( i.e.=100%) then the whole component will have to loaded with the inflation and the Pre tax nominal return becomes [AT Return+ Inflation]/(1-T%).
Expenses are current for the yr. and thus are devoid of any inflation requirement which means all expenditure forming part of required income necessarily is a REAL VALUE for the current year.
It is all common sense with loads of common confusion
Your simple solution – #3 – unfortunately is incorrect.
Or, more accurately, it is not necessarily correct.
It depends on whether the return that is _ not _ withdrawn from the portfolio – the return to cover inflation – is taxable or not. Sometimes it is, and sometimes it isn’t. You have to read the vignette to know.
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