Scenario
A person is graduating from RMIT in 2024 and starting their career at an international company. They plan to purchase a one-bedroom apartment in 2035 and a two-bedroom apartment in 2039. To finance the second property, they will either sell the first apartment or take a bank loan. Using their knowledge of annuities, they must determine how much to save and invest monthly after graduation to achieve their housing goals.
Budget Planning
Budget planning is a critical skill that enables one to better plan their finances. The objective of budget planning is to enhance resource allocation. For purposes of this report, the focus shall be on developing a budgetary plan that enables one to save for an apartment in 10 years and further plan for a second apartment 5 years later.
The assumption made is that the individual shall remain in employment for 15 years, earning a relatively stable income and incurring the same expenses over the years. Further, an assumption is made that in the first year of employment, an investment loan shall be accessible to enable the establishment of a mixed investment portfolio in the form of treasury or government bonds, mixed stock market bonds, and fixed savings accounts with a leading bank in the country. The objective of this report is to utilize capital budgeting techniques to determine how much one needs to save on a monthly and annual basis.
Assumptions
Salary
It is assumed that the salary earned net of statutory deductions shall remain stable and uniform across the years under analysis. The basic pay is assumed to average $18,000 per month for the duration under analysis.
Investment Portfolio
It is assumed that at the beginning of 2025, funds in the form of an investment loan shall be easily accessible and utilized to create a mixed portfolio of diverse investment options. The investment options available are treasury stocks, equity market shares, and fixed bank account savings.
Expenses
It is assumed that, on average, basic expenses shall remain unchanged over the years. Further, an allowance in the form of miscellaneous expenses is made to cover unplanned expenses.
Weighted Average Rate of Return
Based on the assumption that investment funds are available at the start of 2025, the investment portfolio is estimated to be $200,000 in government treasury bonds, $200,000 in a mixed portfolio of different shares in the stock market, and a fixed savings account with a balance of $100,000. The treasury bonds are of mixed maturity duration of 10 years and 15 years where the average expected yield over the 15 years is assumed to be 8% per year.
On the other hand, the mixed stock market portfolio shall be made from diverse shares in the market of diverse risk profiles and yielding an average of 15% per year on the invested amounts. Further, a sum of $100,000 is deposited in a fixed savings account that yields, on average, 11% per year in the form of compound interest. The investment loan and its interest are spread across 15 years at a rate of $42,000 per year or $3,500 per month.
The weighted average rate of return (WARR) is calculated based on the weights and expected rate of return for each investment portfolio item. In this case, the WARR is computed as follows:
The WARR is the average rate of return from an investment portfolio taking into consideration the weights of invested amounts in each portfolio. In this case study, the WARR is 11.40%, implying that, on average, the rate of return received from the investment portfolios is 11.40% on the invested loan amount of $500,000 at the start of the year 2025 to the end of 2039. As such, the investment option is assumed to be discounted at the rate received from the investment portfolio. A discounting factor allows one to discount future cash flows to determine how much should be saved over the years to achieve the targeted future value.
Savings Target – 1st Apartment
Capital budgeting enables one to determine the amounts of savings required to meet a specific target amount (future value) over a specific duration of time. The objective is to determine the average monthly or annual contributions that should be made and achieve the targeted future value at the end of the period under analysis. The discounting rate in this case study shall be the WARR, which implies that the investment is expected to yield a similar rate as when the savings are reinvested back into the current investment portfolio.
The goal is to save for 10 years (2025-2035) and manage to save a future value of $1 million that shall be used to purchase a one-bedroom apartment at the beginning of 2035. Using the price of the apartment as the future value of the savings, duration as 10 years, and WARR of 11.40% as the discounting factor, the minimum savings that should be made are $58,659.54 annually or $4,502.39. The savings amounts were computed using Microsoft Excel’s PMT function.
Savings Target – 2nd Apartment
Further, by the end of 2039, the target is to purchase a second apartment. Considering factors such as inflation and economic factors affecting the real estate market, the price of the second apartment shall be higher, and the selling price of the first apartment increase by 30%. There are two scenarios in this case when considering acquiring a second apartment. First, one can acquire the second apartment by purchasing it through savings.
Secondly, one can resell their first apartment at a profit and add the difference in price to acquire the second apartment. Assuming that the second apartment shall cost $1.7 million, the first option of saving for five years requires that one save a minimum of $270,806.86 per year or $21,152.14 per month.
The second option of reselling the first apartment at $1.3 million and contributing towards saving $400,000 requires that one save $63,719.26 per year or $4,976.98 per month. Considering both options shows that it is more realistic to sell the first apartment towards the end of 2039 and add the difference from savings made in the five years.
Impact of Risk Appetite Towards Investment Planning
Investment decision-making is greatly impacted by the risk appetite of an investor. According to Chattopadhyay and Dasgupta (601), the age of an investor impacts their risk tolerance. The argument is that aged investors tend to be risk averse as compared to younger investors who are new to the investment market. As people age, they often become more cautious with their spending, making them more risk-averse and inclined to wait and see how an investment performs before committing further.
Further, Chattopadhyay and Dasgupta (605) explore gender and conclude that male investors are risk-takers as compared to their female counterparts in investment decision-making processes. Therefore, it can be concluded that demographic factors impact investment decision-making and the level of risk tolerance for a new investor.
Socioeconomic factors impact the willingness and risk tolerance levels of a new investor. Chattopadhyay and Dasgupta (602) argue that married investors tend to be more risk-averse as compared to their unmarried counterparts. This reasoning stems from the idea that as responsibilities grow, people become more careful with their spending and tend to prefer observing how an investment performs before increasing their risk tolerance.
Also, Chattopadhyay and Dasgupta (607) add that the higher the education qualification an investor has, the greater their probability of being risk tolerant as compared to their less educated counterparts. For investors who are employed and/or have a steady income flow, they tend to be more risk takers and tolerant as compared to their counterparts (Chattopadhyay and Dasgupta 607-608). As such, external factors such as life and family commitments impact investment plans and risk tolerance levels for new investors.
Based on the argument on socioeconomic and demographic factors, I would consider taking a moderate risk when it comes to investment decision-making. The rationale is that I would consider that I am entering the job market and would achieve a steady income flow over the years until retirement.
Secondly, the knowledge acquired in class regarding investment decision-making using capital budgeting techniques and market evaluation techniques allows me to be more risk tolerant as I understand how the market works and how to assess the amount of risk and return I would expect from an investment portfolio. Lastly, I would take a moderate risk, considering that I understand how to diversify an investment portfolio by investing more in low-risk investments to cover for high-risk investments made in the portfolio.
Events That Would Impact an Investment Portfolio in 5-10 years
Inflation is the leading economic factor that impacts greatly investment plans and outcomes of most investors. The argument is that an increase in inflation rate reduces the overall returns in an investment portfolio (Phan, Iyke and Sharma 1022). Inflation causes the value of earned returns to reduce below the anticipated value estimated when making the investment decision. As such, an investor may opt to increase their risk tolerance to cover inflation or increase their investment portfolio to earn higher returns.
Political instability in a country delays economic growth and causes economic inequalities and instability. The impact of political instability is that investments yield fewer returns and potentially incur losses due to loss of business and fall in stock market prices (Falato, Goldstein, and Hortaçsu 37). As such, investors are required to be aware of political stability in a country and determine when they should withdraw their investment if they consider political instability will affect the economy of the country.
Natural calamities such as the recent novel coronavirus disease of 2019. The implication of natural calamities is that a country suffers great economic loses and takes time to recover fully (Bourdeau-Brien and Kryzanowski 822). As such, the investment portfolio in such a country shall be impacted by the reduction in economic activities and the slow recovery experienced in 2020-2022. Hence, as an investor, I would take into account such eventualities and consider investing in a more stable investment portfolio, such as businesses that are impacted less by such eventualities, i.e., bonds and debentures.
Works Cited
Bourdeau-Brien, M and L Kryzanowski. “Natural disasters and risk aversion.” Journal of Economic Behavior & Organization, vol. 177, 2020, pp. 818-835. Web.
Chattopadhyay, S and R Dasgupta. “Demographic and socioeconomic impact on risk attitude of the Indian investors – An empirical study.” Asian Economic and Financial Review, vol. 5, no. 4, 2020, pp. 601-623. Web.
Falato, A, I Goldstein and A Hortaçsu. “Financial fragility in the COVID-19 crisis: The case of investment funds in corporate bond markets.” Journal of Monetary Economics, 2021, pp. 35-52. Web.
Phan, D H B, et al. “Economic policy uncertainty and financial stability – Is there a relation?” Economic Modelling, 94, 2021, pp. 1018-1029. Web.
