Portfolio 2 is the optimal portfolio. The Kelley’s time horizon would be characterized as being long term with 3 stages:

1. Time until Sarah is out of college

2. Time until retirement

3. Retirement

The inflows are $50,000 + $15,000 = $65,000 before tax = $65,000 (1-.25) = $48,750 after tax.

The outflows have to be adjusted for inflation since they were last year's costs thus we have:

• $93,750 total costs last year = $30,000 tuition + $63,750 living expenses
• Tuition expenses adjusted for inflation are $30,000 × 1.05 = $31,500
• Living expenses adjusted for inflation are $63,750 × 1.025 = $65,344
• Total outflows this year = $31,500 + $65,344 = $96,844

Inflows - outflows = $48,750 - $96,844 = -$48,094

Required return = 48,094 / 3,200,000 = 1.5% after tax real required return

1.5 / (1-.25) = 2% before tax real required return

Adjusting for inflation = 2.0 + 2.5 = 4.5% before tax nominal required return. Note that due to the tax deferral status of the investments inflation is added on a before tax basis because only the real return is taxed.

Portfolio 2 meets the return requirement and also is in line with their low risk tolerance as indicated by not wanting to be in a security that is too risky. Portfolio 3 is also not acceptable because it is not well diversified and has 20% allocated to cash. Portfolio 1 looks like a good choice, especially with its slightly higher return than Portfolio 2 and broad diversification, however the portfolio has a much higher than necessary cash allocation, and the lack of return from cash seems to be made up for by a 10% stake in venture capital. Portfolio 2 appears to be a better match with the Kelley’s risk tolerance.