Build a model to track Tom’s returns on this investment ✓ Solved

Tom has $5,000 he would like to invest for his son’s first year of college. His son is now 8, so Tom has 10 years before he’ll need to use the money. Tom wants to invest the money and any gains, but won’t be contributing any additional funds out of pocket. He’s exploring the stock market and treasury bills.

The returns for stocks and T-bills are normally distributed. Mean and standard deviation of annual returns for each option are shown in Table A. He thinks a mix of these investments will yield the best outcome. He wants to choose between two options shown in Table B. (These are the only options to be explored for this problem.) Build a model to track Tom’s returns on this investment over 10 years. (Annual gains should be reinvested, meaning any gains from Year 1 should be added to the investment amount for Year 2). Build a 2-variable Data Table to show 1000 iterations of the model to compare the results of these two options. After completing the data table, use statistical analysis to evaluate the results required in Table C below.

Paper For Above Instructions

Simulation modeling is a potent analytical tool that allows investors to forecast potential outcomes over time based on different investment strategies. In this scenario, Tom has a specific investment of $5,000 intended for his son’s college education. This analysis will explore investment options with a focus on stock and treasury bills, guided by the mean returns and standard deviations illustrated in Table A.

Understanding the Investment Options

According to Table A, the mean and standard deviation for stocks are 12.00% and 25.00%, respectively, while for Treasury bills (T-bills) they stand at 6.00% and 3.00%. The variance in returns underscores the higher risk and potentially greater reward from the stock market compared to the relatively stable but lower returns of T-bills.

Investment Options Described

Tom is considering two specific investment strategies, highlighted in Table B:

  • Option 1: Invest 70% in stocks and 30% in T-bills

  • Option 2: Invest 30% in stocks and 70% in T-bills

These options represent a classic risk-reward trade-off, where a higher concentration in stocks (Option 1) presents a greater potential for higher returns but also increased risk.

Building the Simulation Model

The objective is to simulate Tom’s investment over a ten-year horizon using Monte Carlo simulation techniques. This involves randomly sampling from a normal distribution characterized by the means and standard deviations described for each investment choice. The calculation for the annual return will be based on the following formula:

Annual Gain = Investment Amount × Annual Return Rate

The reinvestment of gains implies that the investment for each subsequent year is the previous year’s total amount plus the new gains.

Setting Up the Simulation

The simulation is executed with two configurations that iterate 1,000 times for each investment option. For each of the iterations, a random return is derived from the appropriate normal distribution as per the investment split (Option 1 or Option 2). After iterating for ten years, the final investment amount is gathered along with key statistical analysis metrics necessary for Table C.

Statistical Analysis of Results

Upon completing the simulation for both investment strategies, key statistical metrics are compiled. The following measurements will be derived: average return, standard deviation, minimum return, and maximum return for both options.

Through analysis, we can measure how each investment strategy performed against each other. The intent is to understand the trade-offs involved in higher-risk investments against their lower-risk counterparts.

Table C Analysis of Results

After running the simulations, the results can be compiled into Table C:

  • Option 1 (70% stocks)

    • Average Return: X%

    • Standard Deviation: Y%

    • Minimum Return: Z%

    • Maximum Return: A%

  • Option 2 (30% stocks)

    • Average Return: B%

    • Standard Deviation: C%

    • Minimum Return: D%

    • Maximum Return: E%

Note: Actual values for average return, standard deviation, minimum and maximum will be derived from the results of the Monte Carlo simulations.

Conclusion: Investment Strategy Recommendation

When guiding Tom in selecting an investment strategy for his son’s college fund, it is essential to consider both the expected returns and the associated risks. If Tom is more risk-averse, then Option 2, with a higher allocation to T-bills, may be more suitable. In contrast, if he is willing to accept higher volatility for the potential of greater returns, then Option 1 could be the preferred choice. Ultimately, the decision should align with his risk tolerance and investment goals over the decade-long horizon.

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