Assets |
Holdings |
Cash |
$ 50,000 |
S&P 500 Index Fund |
100,000 |
Analog Devices Inc. |
200,000 |
He asks you to forecast how much the portfolio will be worth in 5 years when he retires. The risk-free rate is 6% per year, the average return on the market portfolio is 12%, the beta of the S&P index is 1.0, and the beta of Analog Devices is 1.5.
a. Cash will earn the risk-free rate = 6%. The return on the index or the market will be the average market return which is 12%. The return on Analog Devices will be calculated by CAPM.
R = Rf + Beta x (Rm - Rf) = 6 + 1.5 x (12 - 6) = 15%.
Hence, the average return will be the weighted average = 50/35 x 6 + 10/35 x 12 + 20/35 x 15 = 20.5714%.
b. The forecasted value after 5 years will be = 350,000 x 1.205714^5 = $891,845.3716
c. The reason of doing differently is that these are the average or the expected values. The actual values can be different for a short period of time but for an extended period of time, they will converge to these average. Also, the data viz. beta and market portfolio return may be backward-looking i.e. historical data. Hence, without forward-looking data, it is difficult to predict the actual values.
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