1. Development of Client Profile
In order to determine the risk appetite of the client and then advising on the appropriate set of investments, it is important to develop a profile of the client. While some of the information is given in the brief, other necessary information is assumed. The client profile is as follows:
2. Risk Appetite
Simply put, risk appetite means an investor’s ability to afford loss of capital. In other words, the more capital an investor can afford to lose, the higher his/her risk appetite, and vice versa. The risk appetite is dependent of various factors, as discussed below:
- Age: usually, the young people are willing to take a little higher risk in search of higher returns. This is due to the fact that 1) young people have no / limited family liabilities, and 2) young people have recovery time on their side, if something were to go wrong. However, as people get older, their ability and willingness to take risk goes down;
- Personality traits: the risk appetite also depends, to a great extent, on the kind of person a particular investor is. Gambler type personalities tend to go for very high-risk all-or-nothing investments, whereas ultra-conservative personalities may go for overly cautious, almost inflation-matching investments. Similarly, men are found to be more inclined towards higher-risk higher-return generating investments, while women tend to prefer safer investments;
- Regularity of cash flow / perception of security: if the future cash flows are perceived to be secure by the investor, the investor tends to go for high risk investments, and vice-versa;
- Financial commitments / family responsibilities: investors with higher financial commitments / family responsibilities tend to prefer safer investments, with the prime objective of capital preservation;
Based on the client’s profile drawn above, factors contributing to the high and low risk appetite are tabulated below, for drawing a risk appetite of the client:
3. Financial Projectionis (upto and post retirement)
Therefore, her investments will need to be oriented in a way to achieve an average annual return of 12% up to the retirement, and 8% for perpetuity after the retirement. Notably, the post-retirement income would be used to meet the living expenses, and may not be invested to further grow the portfolio.
Based on the client profile, the risk appetite, and the average required rate of returns, the financial projections for the client are outlined below:
As can be seen in the table above, post-retirement, the client can not only meet her family expenses comfortably, she can even save a handsome ~ ₤73,000 per annum, which can be further invested to boost the value of her portfolio.
4. Suggested Investments
Based on the client’s risk appetite and average required rate of returns up to retirement (12%) and post retirement (8%), the following investments are suggested:
Up to Retirement Period:
Up to the retirement, her risk appetite is low to moderate. Hence are suggested investments are:
- Fixed deposit / government securities / Bonds: this investment will typically have with long-term lock-in period of, say, 3-5 years or more, and thus is an illiquid investment. This investment is regarded almost 100% safe, and thus would protect the capital.
- Tax saving growth mutual funds with investment only in blue chip companies: the selected mutual funds must have a very good performance track record (at least 10 years) of good performance. This investment also comes with a typical lock-in period of about 3 years, and would hence be illiquid.
- Growth mutual fund in emerging / mid cap, high-risk high return securities: this investment needs to be watched and tracked regularly for timely exits and entries. This is a liquid investment as there is no lock in, and hence would keep 30% of the total investible surplus (₤45,000) in liquid.
- Real estate / REIT: this investment has the potential of generating very handsome returns, due to its leveragability. Also, since real estate seldom depreciates, the capital is also fairly secured. Additionally, the rentals earned from the property pretty much take care of the mortgage obligations. Therefore, this is a hands-off investment. However, real estate is illiquid, can be expensive, difficult to find, and can sometimes get difficult to manage sometimes. In order to overcome the liquidity problem, REITs (Real Estate Investment Funds) are a good alternative to physical real estate. Like a mutual fund, REIT is a fund created with investments from many investors, investing mostly in high value commercial properties, for rental incomes and capital appreciation. REITs are publicly listed entities. Alternatively, she can invest in REIT mutual funds, although REIT mutual funds are more diversified, and may not offer the same growth prospects. One of the good REIT mutual funds is Fidelity Real Estate Mutual Fund.
The post retirement investment suggested is a conservative income mutual fund, which invests only in the safest securities, such as government securities mostly. Also, “regular income” nature of the investment is critical.