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Chapter 10: investment planning.

Investment Planning: The Basics

Few investors, or investment managers, outperform the broad financial markets over extended periods of time. Some investment pundits use this observation to encourage people to go it alone for financial and investment planning. Other financial planners use this observation to argue that individuals should work closely with professional advisors for several reasons.

First, financial planning, and investment planning in particular, is a game of probabilities. A financial planner should be familiar with the odds of success and failure associated with different financial planning strategies. The planner can use that knowledge to help clients make informed decisions even in difficult times.

Second, the financial planner should understand that much of what constitutes success or failure in the realm of personal finance is related to persistence. People are, by their nature, prone to procrastination and indecision. A financial planner can help a client take action through implementation and ongoing management. Simple and sometimes boring investment routines and pragmatism often lead to great success. In other words, financial planners can be effective coaches to prompt clients' continued actions.

Third, financial planners can be very helpful in one of the most important aspects of investment planning, namely, asset allocation. Economic and market changes often mean that investment plans need to change. Unfortunately, many investors, especially those who manage their own portfolios, lose touch with their investments. They forget why they purchased an asset or why a particular investment strategy was being used. Worse, some investors fall in love with a stock or investment strategy and are unable to sell even when the stock, markets, or world events have changed unfavorably. Financial planners must assimilate tax, legal, and market changes important in the management of portfolios and the education of clients.


The development of an investment plan is based on a combination of factors, but foremost is the client's goal(s). Framing of goals and objectives takes place early in the client/planner relationship during Step 2 of the financial planning process. By the time investment recommendations are made, specific goals and objectives should already have been defined, ordered, and assigned priority in the financial plan. For instance, some clients may rank retirement as their principal goal, while others may state that funding a child's education is their number one priority. The type of investment plan developed must match the goal and timeframe identified with the client.

The purpose of this chapter is to review some of the important issues surrounding the analysis of a client's investment situation. The steps in the investment planning process are illustrated in Figure 10.1--the Systematic Financial Planning Process for Investment Planning. The chapter also includes a presentation of popular investment planning strategies, and an example of how strategies can be compared and adapted to meet the needs of clients through client specific recommendations.

Analyze the Client's Current Situation

Analyzing a client's current investment management situation involves a combination of qualitative and quantitative assessments. To this end, investment planning is as much an art as it is a logical system based on fixed rules. A planner must understand the client's perspectives on wants and needs, idealism and reality, as well as a broad range of personal characteristics that may impact investment decisions. The client's stage in the life cycle, as well as the client's goals, time frame, risk tolerance, knowledge and experience, expectations, and financial capacity to engage in risk-taking behaviors all play an interrelated role in determining the best investment approach for a given client.

Regardless of what financial planning model is used for investment planning, the first factors that should be reviewed, prior to developing any specific investment plan, are a client's goals and objectives. If goals have not been determined, it is essential to do so before proceeding with any investment planning. Without a clear understanding of what the goal is (e.g., new home, retirement, university endowment), when a goal needs to be funded or the time horizon (e.g., next year, 10 years, at age 65), and the amount of funding needed, it is unrealistic to assume that an investment plan can be drafted that will remain valid over time.

Determine and Quantify the Client's Investment Planning Needs_

The first step to analyze the client's current investment planning situation focuses on determining and quantifying the client's planning needs. Temperament, personality, attitudes, and beliefs are particularly salient factors in the development of client-specific recommendations that are efficient and effective. Too often, investment planning decisions are based initially on the assets available, without sufficient consideration for other client situational factors that should be instrumental in the products and strategies chosen. Although the assessment of the client's investment planning need is multi-faceted, most professionals agree that an investment plan should be based on five key interrelated factors.

These five factors include a client's risk tolerance, knowledge and experience, expectations about future market conditions, time horizon, and capacity to take risk. The first three represent client situational factors that are inferred, meaning that they are more reasoned than measured. A more complete understanding of these and other situational factors should emerge from the evolving planner-client relationship during the discovery and data gathering in Step 2. Other insights into the client's temperament and personality, as well as attitudes, beliefs and behaviors, should also guide the advisor in the formulation of the investment plan. The last two factors, time horizon and financial capacity to withstand risk (or loss), are more quantitative in nature because they can be more easily measured.

It is essential that both qualitative and quantitative situational factors be considered before and during the development of investment strategies. The increased focus on the codification of investment policy statements is an example of the broader focus on the "whole" client. For example, the investment plan, client communication, and client education may, by necessity, be very different for a highly emotional and reactive client who is unduly influenced by short-term market trends than for a client who takes a more tolerant, long-term outlook.

Arguably, the most important situational factor in the investment planning process is a client's risk tolerance, which is defined as the maximum level of uncertainty a client is willing to accept when making an investment decision. Developing an understanding of, and an appreciation for, both the time and psychological dimensions of risk is essential.

It is possible for a client to have a long time horizon concurrently with a low proclivity towards risk. However, in almost all cases, a person's risk tolerance will supersede other influential factors in asset allocation choices. To possibly mitigate the effects of risk-adverse behavior, a planner must be willing to explain to the client that goal achievement may not be possible in the given time horizon if the client is unwilling to accept additional risk. But even with additional coaching, if the client's tolerance for risk is low, it is likely that an aggressive strategy will be abandoned if the client is faced with prolonged losses.

Occasionally, a client's risk tolerance is so low that the financial advisor has almost no choice but to recommend very liquid insured accounts (e.g.., savings account, CDs, and money market deposit accounts). In the most severe cases, a client may almost demand the singular use of FDIC insured bank accounts. Then it will be up to the planner to optimize the client's earning power while maintaining complete FDIC coverage of the client's accounts. While the use of insured accounts is certainly limiting, these investments may be in the best interest of the client, and the only way a planner can get the client to stay the course. In cases like this, annuities can be one possibility to get a client to invest in the market while having a small safety net, because many insurance products have a guaranteed death benefit.

The second factor influencing investment planning decisions is managing a client's expectations. These expectations include: what the planner can do, the general economy, and, most notably, the achievable rates of return. The most successful planners rarely compete based on their ability to generate the highest possible rates of returns. Instead, the best planners work daily to manage client expectations about performance.

Consider a planner who suggests a 12% return, but only manages to generate a 10% return. The 10% return may be excellent. In fact, the return may be superior to almost all other strategies available; however, clients working with this planner may very well be disappointed. Some clients will leave the planner because they had expected a return higher than what was obtained.

Now consider a planner who consistently informs clients that an 8% return is reasonable, but over the course of three to five years generates 10% returns for clients. The return is the same as the aggressive planner, but the outcome is significantly different. Clients working with the second planner are likely to feel that they have received a bonus.

An investment plan should be tempered by a client's expectations and satisfaction with the current financial situation. Managing these expectations requires the planner to not only measure, but understand, the client's view of market trends, both past and future. Viewing the investment marketplace and economy without the planner's knowledge rationalizing the client's viewpoint is akin to trying to see underwater without goggles on. While wearing the goggles of experience, the planner can see more clearly what is happening and is able to adjust more quickly to changing conditions. It is therefore necessary to account for investment and economic expectations when developing investment plans. A person's outlook, be it negative or positive, should be used as a moderating factor when developing an investment plan.

The table below provides a sample of the types of questions to ascertain a client's expectations about the future economy and satisfaction with the client's current situation. Answers to the first question are particularly important when developing investment planning strategies. If a client truly believes that the economy will perform worse in the future, and if the planner concurs, the level of risk taken to meet a financial goal should be reduced accordingly. Similar adjustments, either positive or negative, can be made based on responses to other questions. For instance, if a client is not satisfied with a chosen career, this could be an indicator that a career change may be a possibility or that the potential for significant promotions or salary increases may be limited. It would be imprudent to invest the client's assets aggressively--reducing marketability and liquidity--if there is a possibility that assets will be needed to fund job search expenses and other costs. Furthermore, the capacity to withstand risk and the availability of assets to invest must be realistically assessed.

As should be apparent, expectation and attitude assessments can provide only a starting point in leading to client/planner discussions. However, questionnaires and scale items are not necessarily prescriptive in and of themselves; it takes a planner's insights and experiences to decipher the impact temperament, personality, attitudes and beliefs will have on the investment planning process.

Additionally, a planner is expected to know the investment terrain and a client's level of investment knowledge and experience. Beyond the regulatory requirements of understanding a client's knowledge level, financial planners will have fewer objections to overcome if they present investment alternatives that the client already has an understanding of or experience with. The fifth sample question can be helpful in determining how much to reduce the variance of returns, or overall volatility, within a portfolio.

Clients with low levels of financial knowledge tend to be less risk tolerant than others, holding other factors constant. Investing too aggressively for someone with a lack of knowledge about the investment markets is a receipt for panic selling if and when a prolonged bear market hits. Conversely, by increasing the client's level of knowledge about the investment and by establishing shared expectations about the probable performance of the investment, the plan has a greater possibility of success. To return to the goggle example, the planner should help the client see by sharing the goggles. This accomplishes two things at the same time. First, the client's level of knowledge increases. Second, the planner will gain greater insight into the client's perspective by occasionally removing the goggles.

While the qualitative factors of investment planning are very critical to the long-term viability of the plan, the quantitative factors of time horizon and risk capacity may be more important in the short-term. Suggesting that a client invest heavily and aggressively in a retirement account is certainly sound advice if the client is 50 years old and risk tolerant, and retirement funding is the client's primary goal. But making the same suggestion to an equally risk tolerant 25 year old who does not have an emergency fund may ignore the time available to realize the goal or the financial capacity to take on risk associated with this plan.

Time can be either a client's greatest asset or liability. Time horizon can be defined as the time period between goal formation and goal achievement. Someone, for instance, who starts planning for retirement at age 25 will find that time is a great ally. Someone else who waits until age 50 to plan for retirement will most likely discover that time is an enemy. Time allows a client to invest more conservatively and still maintain the same likelihood of goal achievement. Some would argue that a long-term conservative investment strategy results in the highest probability of a positive outcome. Another way of viewing a longer time-horizon is that a client can invest less money on a periodic basis at a higher expected rate of return because greater volatility can be withstood.

For example, assume that two clients have the same goal of saving $1 million by age 65. Both have $250 per month available for saving. One client is 25 years old, and the other is 35 years old. In this situation, the older client would need an average rate of return of about 12.6% to reach the goal. This is possible, but at what level of risk? Comparatively, the younger client needs only to average about 8.5% to achieve the same goal. This is also possible, even probable and at a much lower level of risk. As the example illustrates, the greater amount of time a client can devote to saving and investing for a goal, the higher the likelihood that the client will accomplish the goal. Because risk and return in the security's market are highly positively correlated, those with longer time horizons will generally be more likely to reach their financial objectives.

Lastly, a client's capacity to accept risk is an important factor to consider when making investment plans. Risk capacity measures the amount of financial cushion or safety net available to a client both before and after an investment decision has been implemented. Some clients are not prepared to take risks with their assets because they simply do not have enough assets when compared to their other financial obligations. Documenting and assessing a client's risk capacity is especially important when tempering initial portfolio risk profiles based on time horizon and risk attitude. Often, the maximum amount of risk that a client should be willing to take, given the client's time frame, risk tolerance, expectations, and attitudes, is higher than what the client can fiscally afford to lose.

The best way to assess a client's capacity for accepting risk in an investment portfolio is to review the financial situation with financial ratio analysis. Because ratios focus on the relationships between financial assets and liabilities or income and expenses, the planner can assess a client's need for financial liquidity and stability. This is done by determining how many ratios meet prescribed benchmarks (see Chapter 3) and the availability of an emergency fund. A client who has several ratios that meet or exceed the benchmarks may have significant risk capacity. Excess capacity may allow a client additional flexibility with longterm investments because the client will have the capital to cover an unexpected expense without liquidating long-term assets. Another client who meets or exceeds only one or two ratios could be considered to have a lower capacity to take risk. This need for additional liquidity and stability would mean that the planner should not recommend long-term volatile investments, even if the client has the tolerance.

Determine a Client's Required Rate of Return

The discussion, up to this point, has dealt with a client's investment in relation to a client's preferences or their current financial situation. However, there will be times when investment decisions need to be based on projected investment outcomes rather than current attitudes and financial circumstances. In these cases, rather than making allocations that just happen to result in a certain rate of return, a planner and client may allocate a portfolio in order to achieve the needed expected rate of return. This reverse engineering has its advantages if all goes as planned; however, if the results are not achieved, then maintaining client satisfaction will be harder because the client might be less comfortable with the level of risk exposure or the amount of volatility. Reverse engineering can be seen by looking at the example of the 35 year old client who wants to retire at age 65 with $1 million; if there is $250 to invest on a monthly basis, the portfolio must be allocated to achieve an annual rate of return of more than 12.6% (ignoring the impact of income taxes). This rate of return is simply the required rate that achieves the objective and does not consider the client risk tolerance or risk capacity.

In principal, calculating the required rate is a simple time value of money equation where the future value is $1 million, the present value is $0, the periodic payment is $250, and the number of periods is 360 ((65--35) x 12). In practice, having a required rate of return dictate an asset allocation, rather than having the client's risk profile dictate the targeted return, is a dubious proposition and should only be recommended for a knowledgeable client with the capacity to accept the risk.

Unfortunately, if the client's risk profile does not match with the required portfolio, then the client has a difficult choice to make. The client has to learn either to be comfortable with the additional risk required, to increase the amount of money available for savings, to reduce the desired goal amount, or to delay goal achievement. Any of these compromises could derail an investment plan and undermine the client/planner relationship.

Determine a Client's Asset Allocation

Asset allocation is how a client's investment dollars are spread among different financial assets classes. Financial assets can be broken into many asset categories for asset allocation purposes, based on either the client's preferences or the current and projected market conditions. Figure 10.3 briefly outlines the primary asset classes and a suggested use for each.

Planners must not only consider the asset classes available, but also consider both client specific factors and economic factors when allocating a client's assets. Client specific factors involve answering two questions. First, what is the client's goal--current income, capital appreciation, or capital preservation? Second, how aggressively allocated does the portfolio need to be to achieve the goal? Aggressiveness can be loosely defined as the amount of additional risk a portfolio is subjected to for a corresponding incremental increase in potential returns. In other words, the more aggressive the portfolio, the greater is the expected return of the portfolio, but the higher the anticipated volatility--or risk.
Figure 10.3 A Summary of Investments by Asset Classification

Equity (stocks).The primary purpose of equity investing is capital
appreciation. Stocks have historically had the highest asset
returns after adjusting for inflation. A secondary purpose of
current income is possible if investing in stocks that pay a high


* Large-cap--stocks with a market capitalization over $10 billion.
These stocks are typically mature, dividend paying companies

* Mid-cap--stocks with a market capitalization between $2 billion
and $10 billion. These stocks may not pay dividends, but have
higher growth rate prospects than large-cap companies.

* Small-cap--stocks with a market capitalization under $2 billion.
These stocks typically do not pay dividends because they are less
mature, but fast growing companies that retain earnings to fuel

Debt (bonds).The primary purpose of debt investing is current
income. Bonds typically pay interest on a regular and recurring
basis without the possibility of interest reinvestment. A secondary
purpose of capital appreciation is possible if investing in a
declining interest rate environment.


* Treasury/government agency--bonds issued by the Treasury
Department or a federal government agency.

* Municipal--bonds issued by state and local government. Can be
further classified as general obligation bonds or revenue bonds.

* Corporate--bonds issued by public corporations. Can be further
classified as investment grade or high-yield issues.

* Zero coupon--bonds that are sold at a discount to par value and
do not pay a periodic payment. Typically, these bonds are issued by
the federal government in the form of Treasury Strips; however,
other zero-coupon issues are available.

International. The primary purpose of international investing is
diversification, with capital appreciation being a secondary focus,
especially during times of superior international growth.
Sub-classifications include the equity and debt of both developed
markets and emerging markets.

Commodities. The primary purpose of investing in commodity assets,
for the average investor, is capital appreciation, especially in
times of rapid hard asset price growth. Commodities can serve as an
inflation hedge. Sub-classifications include precious metals,
natural resources, energy products, livestock, and agricultural

Real Estate. The primary purpose of real estate investing is
current income. Real estate investment trusts (REITs) typically pay
dividends on a regular and recurring basis. Capital appreciation,
as a secondary focus, is possible with some forms of direct real
estate investment. Sub-classifications include raw land,
agricultural, commercial, residential, and mortgage-backed

Figure 10.4 summarizes the risk and return characteristics of commonly used investments. The level of aggressiveness required within an asset allocation structure depends heavily on the difference between the current value of invested assets and the desired level of invested assets. The difference between current (present value) and needed (future value) assets and the time horizon dictate the required rate, all other factors, such as additional deposits, held constant. However, the use of the portfolio, to a certain extent, also dictates the required level of aggressiveness or risk required.

Investments are bought and sold, not only due to changing investor goals, risk attitudes, and time horizons, but also due to changing economic factors. A planner should consider the current and prospective economic environment when changing an asset allocation model. This process of economically-based asset allocation can be outlined with the following questions.

* What is the primary purpose of the portfolio--capital appreciation or current income?

* Are domestic interest rates rising or falling?

* Are the projected monetary and fiscal policies of the U.S. conducive to strong long-term growth?

* Will the U.S. dollar rise or fall in value relative to foreign currency?

* What are the projected domestic and international growth rates?

* Will inflation or rising commodity prices stunt growth domestically or internationally?

* Will foreign investments offer superior risk adjusted returns?

It is important that the client understand why certain asset allocation suggestions were made. A planner must be careful not to overwhelm the client with too much financial or economic information. To begin the economic allocation process, most financial planners will mentally segregate assets into a two-by-two Investment Selection Matrix.
Investment Selection Matrix


            Appreciation    Income

High         Commodities   Real Estate
Low            Stocks        Bonds

The matrix consists of stocks, bonds, commodities, and real estate (hard assets such as collectibles are typically not considered investment assets because their value is determined more by supply and demand). Each one of these categories has pros and cons, but it is the strategic allocation of all types of assets that yields the greatest benefit. The basic premise behind this mental accounting is that real assets, such as commodities and real estate, often perform better than financial assets, like stocks and bonds, in times of high or increasing inflation; and the opposite often holds true in times of low or decreasing inflation.

By considering the impact of economic conditions, the planner can optimize the portfolio allocation by changing the weight of a particular class of assets. An example of an allocation that might perform equally well in times of high or low inflation may be a portfolio split 25% to each asset class. However, this might not work if the client wanted to maximize current income. So the planner must change the portfolio based on both the economy and the goal of the client.

The current income versus capital appreciation question assists the planner in developing the basic guidelines for the allocation that will best suit the client. Typically, planners suggest real estate and bond holdings to maximize the income potential of a portfolio, and stock and commodity holdings to maximize the appreciation potential. However, the 25% equal allocation might not work, for example, due to high expected inflation. So the planner must focus on both the economy and the goal of the client.

The next question that might be considered is the foreign or domestic investment focus. The primary objective of foreign investment is the reduction of the systematic risk associated with investing in only one country or region. However, superior returns may also be achieved with international investing by capitalizing on changes in currency exchange rates or higher international growth rates associated with emerging or recovering markets. In either case, adding international diversification to an asset allocation model can increase the overall riskadjusted return of a client's portfolio.

The final question pertains to the current and projected interest rate environment. By applying the rule to fixed-income securities (bonds) that as rates rise, values fall, a planner should allocate a portfolio that is not overly sensitive to rising or falling interest rates. Returning to the original 25% balanced allocation example, it is easy to see that, in a time of rising interest rates, a planner may want to reduce the bond allocation to mitigate any possible negative consequences.

Single or Multiple Asset Allocation Models

Another issue that should be considered when building an asset allocation model is whether the client and the planner choose to treat assets as if they were in a single bucket that supplies all goals or in multiple buckets, each with a singular goal. For instance, instead of choosing a single moderate allocation for all assets, the planner and client might opt to select an aggressive allocation for retirement assets and, separately, build a more conservative model for a shorterterm goal, such as a down payment for a home or a child's wedding. The financial planning profession does not seem to have a preferred method when choosing between these methods.

There is a debate among academics regarding portfolio management strategies, investment planning, and asset allocation approaches. Some financial planning practitioners and academics believe that a client's total asset allocation structure should be evaluated simultaneously. Advocates of this approach argue that a client's financial situation is integrated and, as such, it is impossible to solve one financial situation without impacting other client issues. Furthermore, advocates of this approach maintain that it is simply foolish, for instance, to consider a person's portfolio for retirement separately from assets saved for an emergency, because few clients would maintain their retirement savings in the face of an emergency.

Other academics and planners argue that, in fact, clients and planners alike tend to use mental accounts to separate assets for different purposes. Clients often keep assets in low yielding savings accounts even though they could invest the funds for high rates elsewhere. Why don't they? Behavioral finance theory may provide an answer. According to the theory, nearly all people separate assets into mental accounts. People sometimes feel that they need immediate access to cash. They are willing to sacrifice return for this security. The use of mental accounts may not always be prudent in financial planning, but it makes perfect sense in helping people manage their daily lives. Because of the psychological ramifications associated with money and investing, a large number of planners argue that asset allocation models be developed for each client goal and objective.

Using a separate allocation methodology, a client would be shown a current and recommended asset allocation for various planning case issues, including an emergency savings allocation, life insurance allocation (assuming a variable or variable universal life policy is used), retirement planning allocation, education funding allocation, and other situational funding allocations. Each separate allocation would show the portfolio's asset categories, rates of return, and relevant modern portfolio statistics.

Regardless of which method is used, it is important to be as specific as possible when describing a portfolio and asset allocation approach. This is particularly true when detailing changes in a portfolio. Clients need to know if their current asset allocation approach matches their risk profile. If not, specific recommendations should be made to adjust the portfolio to match those parameters. Implementation strategies should be both concise and precise, telling a client when, where, and how a change should be made. The results of changes should also be documented. Apart from how a planner and client think about the mental accounting of assets, the most basic idea behind asset allocation is not to put all investment assets in one basket.

Document and Evaluate the Current Investment Management Situation_

The second step in analyzing a client's current situation, and certainly a step that must be completed before a planner can recommend additional or alternative investments, entails documenting and evaluating all investment plans currently in place, whether assets are allocated or unallocated for a specific goal. An initial assessment may focus on the client's stage of the financial life cycle and whether the current investment plans match the life cycle objectives and the other client characteristics. It must be noted that changing family dynamics (e.g., delayed marriage, remarried or repartnered families, etc.) may limit the usefulness of the life cycle approach, but the broad generalizations can be very important when educating clients.

The financial life cycle is typically conceptualized as three stages: protection, accumulation, and distribution. This approach can provide direction and meaning by helping clients to understand and anticipate how each financial decision affects subsequent decisions. The following is a short discussion on how the investment focus, or overall objective, changes as the client progresses through the life cycle stages.

During the protection stage, a client should develop a budget and emergency fund to meet unexpected expenses. Regrettably, some young clients may focus on the later stages too early and be unprepared for the unexpected. As a result, they may find themselves raiding investment assets in the event of an emergency. Having a financial planner focus on protection ensures that clients' future risk capacity matches or exceeds their risk tolerance. Also, having the tolerance to invest aggressively, but not having the capacity to do so, can result in unnecessary frustration for both the client and the planner.

Next is the accumulation stage, during which the client begins building wealth. This stage can last from 20 to 40 years. Generally, clients want to save for retirement, purchase a bigger home, fund a child's education, or buy a new car. The list can go on and on. It is the financial planner's responsibility to recommend actions that will enable the client to meet these savings objectives in an as efficient manner as possible. By closely monitoring the client's investment profile for changes and reallocating the client's portfolio as necessary, the planner can safely and effectively guide the client through the most challenging stage of the client's financial life.

While the last stage, distribution, may seem to be neatly divided from the accumulation stage at a client's retirement date, there are many clients that continue to accumulate wealth well into retirement. At this point in the life cycle, the planner begins to suggest titling and gift strategies that minimize any potential asset transfer difficulties. Portfolio allocation and reallocation also becomes much more intense, because failure in this stage could be disastrous.

With all of this delineation, it may seem counter-intuitive to state that a client may never actually "complete" each stage before moving to the next stage. But, in reality, changing stages is more of a change in focus than a predetermined date. A client could even be accomplishing tasks in all three phases at once. In summary, life cycle investment planning is not just about the issues of today or next week, it is about anticipating the needs of the client as the client ages. By viewing each financial decision as part of a whole, planners and clients alike can consider both the short and long-term effects the current decisions have on the client's future life goals.

Determine a Client's Investment Profile

Once the five initial factors of investment planning are known (i.e., risk tolerance, knowledge and experience, expectations about future market conditions, time horizon, and capacity to withstand risk), the planner can start combining the factors to build a client's investment profile. A client's profile can initially be estimated by looking at the person's time frame and risk tolerance for goal achievement. The following table illustrates how the combination of time frame and risk tolerance can be used to estimate a base-level of investment risk (i.e., volatility) that would be appropriate for a given client goal.

The fact that clients typically have more than one goal, each with a different time horizon, implies that multiple investment strategies will need to be designed. In order to use this table, it is essential that planners use a reliable and valid riskassessment instrument. It is also important to remember that the guidelines shown in the table will need to be tempered by an assessment of a client's attitudes, expectations, and risk capacity. Given this caveat, however, the guidelines provide general guidance on the level of risk that might be appropriate for a client.

Example. A client is saving for retirement in 20 years. After taking a risk assessment quiz, it is apparent that the client is neither a real risk taker nor a risk avoider. Given the length of time as the primary factor, an aggressive portfolio could be prescribed as a starting point in client discussions.

Knowing only a client's time frame and risk tolerance is not enough information to formulate an effective investment plan. These factors alone tell less than half of the story. In order to get a full picture of a client's investment profile, it is also important to assess a client's investment attitudes and expectations. For instance, some clients may be open to any type of investment within their portfolio, while others may prefer to employ screens to eliminate certain types of investments. Screens related to socially responsible investing, religious beliefs, or political affiliations are examples of how attitudes can impact the structure of an investment plan. Other types of attitudes need to be evaluated as well. It would be helpful, for example, to know whether a client is content with regard to the current level of investment income, taxes paid on investment earnings, and level of volatility.

Answers to these types of questions can help an advisor either moderate or enhance the risk profile of a portfolio beyond what might be appropriate if only time and risk are accounted for. The Client Attitudes Questionnaire, below, gives an idea of the kinds of attitudinal questions that can be asked by a planner. Strong preference by a client can be used by the planner to better understand what might be driving a client to seek help with investments.


Comparing a Client's Investment Profile to the Current Portfolio

Taken together, a client's time frame, risk tolerance, knowledge, expectations, and risk capacity can be used as the basis for better understanding a client's current situation. Once this part of the current situation analysis is concluded, it is appropriate to look at portfolio characteristics in more detail. Specifically, it is important to document whether or not the client's current portfolio matches the client's investment profile and goals.

Example. A client has a long-term time horizon, a moderate level of risk tolerance and financial knowledge, generally positive attitudes and expectations regarding investing, and an intermediate level of risk capacity, but a portfolio that is invested fairly conservatively. The planner concludes that more portfolio risk could, and probably should, be taken by the client, thus increasing the expected return of the portfolio.

One of the key questions associated with an investment planning current situation analysis is whether or not a client needs to make a portfolio change to better meet the financial goals. There is no definite quantitative way to answer this question. But there are distinct approaches that can be employed to make the process easier.

One approach to quantifying how a portfolio corresponds to a client's investment profile is to document relevant portfolio characteristics using a standardized form, and then compare these characteristics to market benchmarks. The Investment Profile and Portfolio Summary Form is one form that can be used in this process.


This form begins by documenting the situational factors that affect a client's investment profile. An investor profile, based on these factors, is then determined. Although no universal scale is available, this table uses a 5-step investment risk profile scale--5: High, 4: Above average, 3: Moderate, 2: Below Average, 1: Low. A planner would then match these risk classes with suggested portfolio allocations. (A completed form with a model allocation is shown in the comprehensive example later in this chapter.)

The client portfolio allocation profile is the basis for choosing the benchmark portfolio. Benchmark statistics should then be entered into the table. For example, if a planner determines a client's investment profile falls in the "moderate" range, then statistics for a balanced growth portfolio, such as the Morningstar Moderate Allocation Portfolio, could be entered in the benchmark column. Next, relevant portfolio statistics should be summarized and the actual portfolio statistics compared to the benchmark.

While the comparison of statistics can be documented in terms of higher, lower, or the same, there are few rules for use in determining if the current portfolio is superior or inferior to the benchmark. Modern Portfolio Theory, its related statistics, and various other investment rules can be used to determine if a client's portfolio is efficient and effective. However, in many cases, the choice to recommend portfolio changes comes down to a planner's professional judgment. Experience, knowledge, and skill help a planner determine whether a portfolio is appropriate for a client's needs considering the current economic situation, client attitudes and expectations, and an analysis of risk tolerance and capacity. It is the integrated nature of these, and other situational factors, that makes investment planning challenging.

Common Investment Statistics and Calculations_

In order for an investment market to exist, there need to be people who, or institutions that, have more money than they need, and others who need more money than they have. The interests of these two groups are at odds. Those who need money would like access to it at the lowest possible cost. Those who have money want to receive the greatest possible compensation. In fact, they require two types of compensation in exchange for the use of their money. First, some compensation is required in exchange for delaying the opportunity to spend the money. The minimum compensation clients require for delaying consumption when they are unwilling to accept any other risk is the risk-free rate of return.

The second compensation required is for accepting risk, or the risk premium. There are multiple risk premiums that may be assigned to an investment. Equity investments typically are assigned risk premiums associated with business risk and market risk. Bonds, on the other hand, have risk premium assigned for default risk and interest rate risk. International investments could have premiums for exchange rate risk, liquidity risk, or political risk. This is not to say that these risks and risk premiums are exclusive to any one class of investment, the examples represent the typical assignments. However, there are several risk premiums that are associated with all investment classes. They include business risk and inflation risk. While an in-depth discussion of all types of risks may be warranted, a general understanding of two of the more pervasive types of risk is necessary, and cursory discussions of several others will occur throughout this section.

Default risk, or credit risk, is the risk that investors will not be paid what they are contractually owed. Because U.S. Treasury issues are backed by the full faith and credit of the U.S. government, the issues are said to be default risk free. However, other investments, such as money market mutual funds or bank accounts, are also virtually default risk free and therefore offer similar rates of return.

The T-bill rate is often quoted as the risk-free rate, except that even the riskfree rate of return is not totally free of risk. The T-bill rate is quoted as a nominal rate of return, and thus its return is impacted by inflation. However, since inflation affects all nominally-priced investments, freedom from default risk earns the T-bill the "risk-free" designation as a shortcut term. For clients to be willing to accept any additional amount of risk, a premium to the risk-free rate will be required. The risk premium will depend on the type, severity, and probability of the risk, as well as the time horizon of the investment.

Possibly the most costly risk faced by investors and non-investors alike is inflation risk. Consumers can either spend now or spend later. But, to spend later in an inflationary environment means that the consumer will have to spend more money, in nominal terms, to purchase the same amount of goods and services. Therefore the purchasing power of the money declines over time. It is worth noting that the majority of individuals who keep their money in savings accounts generally do not receive adequate compensation for the inflation risk they take. If, for instance, inflation averages 4% and an account earns only 1% in interest, the real purchasing power of the savings declines by about 3% annually, and that is before taxes are incorporated into the calculation.

The following table shows inflation as measured by the Consumer Price Index (CPI).

Notice that inflation, averaging approximately 3%, has remained relatively benign. Yet, even at recent inflation rates, it would take about $180 in 2007 to purchase what could have been bought for $100 in 1988. If inflation edges up to, say, 5% on average, clients will lose half of their purchasing power about every 14.4 years (72 5). To counteract the erosion of their purchasing power, clients expect compensation that at least offsets this reduction. Therefore, a financial planner should generally attempt to develop portfolios that can at least match the rate of inflation.

Risk is at the root of most clients' concerns when making an investment. Beyond the individual sources of risk, there are two primary forms of risk faced by investors: systematic and unsystematic risk.

Systematic risk, also called market risk, is embedded in the system of the financial markets. This type of risk cannot generally be eliminated through diversification. Assume, for example, that the markets experience a significant one-day drop in value, such as occurred in 1929 and 1987. Regardless of the amount of diversification held within a portfolio, anyone invested in the stock market would have lost money on their unhedged investments.

Examples of systematic risks faced by investors include political, regulatory, and volatility risks. Political changes can have widespread impacts on the markets. For U.S. investors, these can range from changes in the tax code to greater business regulation. Political risks can be even more exaggerated if the portfolio contains overseas investments, particularly in emerging markets. Generally, the political systems in such countries are less developed and new leadership can signal dramatic change. U.S. investors who invest overseas need to also account for exchange rate changes. In general, a declining dollar makes U.S. exports and foreign investments more attractive. When the dollar strengthens against foreign currencies, U.S. investors can actually lose money on foreign investments, even if the investments make money nominally.

Another important systematic risk is the overall level of compensation investors require for taking risk. During the Internet bubble of the late 1990s, investors were willing to accept little compensation for added levels of risk. At any time, investors as a whole may require more compensation for the risks they take, which will cause the value of securities to either stop increasing, stagnate, or start decreasing, deflate. This was the case immediately following September 11, 2001.

Unsystematic risk or firm risk, on the other hand, is a type of risk that can be managed and reduced through diversification. Diversification involves blending assets that are not highly correlated within a portfolio to reduce risk exposure. Business failure is perhaps the greatest unsystematic risk. Businesses can fail due to poor management (business risk), or by taking on too much debt (financial risk). Certain securities, such as collectibles or high-yield bonds, can go months without trading. Investors may be unable to sell their position should they require funds, introducing liquidity risk.

Portfolio Statistics--Historical Data_

Asset Mean "Average"

As discussed in Chapter 2, the most basic investment statistic is the average return. This is known as the arithmetic average, or "mean." It is sometimes designated by u. Typically, this is the most easily understood investment statistic, the one that is most sought after by investors, and the most quoted by investment providers. This statistic is also the basis for all other Modern Portfolio Theory related statistics such as variance, standard deviation, coefficient of variation, and the Sharpe Ratio.

Average Return (AR) = [r.sub.1] + [r.sub.2] + [r.sub.3] + ... + [r.sub.n] / n


r = Return for Period n = Number of Periods

However, unless a client is investing in a fixed-return asset, such as a bank CD, then most periodic returns will vary over time; so, an average return only tells half of the story. Basically, this means that while the returns should averageout in the end, the returns during any given period will likely be either above or below the expected long-term average. When returns vary around an average, most predictions of future returns assume the average will prevail.

Asset Variance

One of the primary measures of risk deals with the fluctuation of individual return around an average return. The greater is the dispersion of returns, the higher is the return volatility; hence, the higher is the risk. The difference between the average return and the range of possible outcomes is known as variance, denoted by [[sigma].sup.2]. Variance is calculated by subtracting each individual outcome from the average outcome and then squaring the difference.

Variance = [(outcome-average).sup.2]

or [[sigma].sup.2] = [([X.sub.t-u).sup.2]


Variance = [[sigma].sup.2] Outcome = [X.sub.t] Average (Mean) = [mu]

While the individual security variance statistic does hold some information, the more important statistic is the average variance. This calculation simply involves adding variances together and then dividing the sum by one less than the number of outcomes in the sample.



n = Number of Observations or Units

Example. Assets A and B have the following returns.
Nominal Rates of Return      Asset A      Asset B

2003                         -12.0%        -2.9%
2004                           4.2%         6.5%
2005                          11.8%         9.0%
2006                           6.1%        -3.7%
2007                           9.3%         7.5%
Arithmetic Mean               3.88%        3.28%

By applying the above formula, the planner is able to determine that Asset A has a variance of 0.00873 and Asset B has a variance of 0.00370.

Asset Standard Deviation

A risk measure related to and predicated on variance, denoted as a lower case sigma ([sigma]), is standard deviation. Standard deviation is the square root of variance, and is more commonly quoted and used in investment statistics than variance. Standard deviation can be very useful in determining the dispersion of possible, or past, outcomes in relation to the expected outcome.



[sigma] = Standard Deviation

n = Number of Observations or Units

[r.sub.i] = Actual Return

[mu] = Average Return

Again using the variance example, it is easy to see that, because the annual outcomes are different, the standard deviation will be greater than zero. (In fact, the only time standard deviation, and variance, will be zero is if all outcome over the analysis period are identical.) The table gives 5 individual outcomes and the arithmetic average of those outcomes. Using the preceding formula above or applying the square root formula to the variance derived above, the standard deviations are calculated as 9.34% and 6.08%, respectively for Assets A and B.

Coefficient of Variation of an Asset

The coefficient of variation, CV, is another measure of dispersion (range); but in this case it is a relative measure based on average returns. CV is a ratio of unit of risk per unit of return. Therefore, it is easy to see that, for this ratio, smaller numbers are superior to larger ones. This measure is useful in comparing the risks of various investments with different expected returns. Therefore, to calculate the CV for only one asset offers very little insight. The equation for CV is:

CV = [sigma] / [mu]


[sigma] = Standard Deviation

[mu] = Mean

Again, consider the same two possible investments, Asset A and Asset B. To determine which asset offers the greatest return for a given level of risk, the risk of each asset (standard deviation) must be divided by the average return of each asset (arithmetic mean).
Nominal Rates of Return      Asset A      Asset B

2003                         -12.0%        -2.9%
2004                           4.2%         6.5%
2005                          11.8%         9.0%
2006                           6.1%        -3.7%
2007                           9.3%         7.5%
Arithmetic Mean               3.88%        3.28%
Variance                      0.87%        0.37%
Standard Deviation            9.34%        6.08%

CV Asset A = 9.34 / 3.88
           = 2.41

CV Asset B = 6.08 / 3.28
           = 1.85

By comparing the two assets without an adjustment for risk, a financial planner may pick Asset A, the riskier asset, because of the higher average return. However, after calculating the coefficient of variation for both assets, the planner may conclude that Asset A does not offer enough additional return for the increased level of risk.

Another use of the coefficient of variation involves determining the appropriate level of return for an increased level of risk. Returning to the example, a financial professional sees that Asset B experiences 1.85 points of risk for each point of return. Therefore, in order for the planner to choose Asset A, a similar or lower ratio would be necessary. To determine what level of return would be required for the level of risk associated with Asset A, use the CV formula below.

Required return to equalize the CV = Standard Deviation of Asset A / CV of Asset B

Required return to select Asset A = 9.34% / 1.85 = 5.05%

Correlation and Covariance

Diversification is a method used to reduce unsystematic risk within a portfolio. However, to maximize the benefit derived from diversification, it is important for a financial planner or portfolio manager to select assets that do not react the same way to a given economic environment. Covariance and correlation are measures of the degree to which multiple assets move in tandem.

Covariance measures the linear relationship between two random variables. The formula for covariance is:

[[sigma].sub.ij] = [[sigma].sub.i][[sigma].sub.j][[rho].sub.ij]


[[sigma].sub.ij] = Covariance of assets i,j

[sigma] = Standard Deviation

[[rho].sub.ij] = Correlation of assets ij

Notice that the formula above for solving covariance and the formula for solving correlation are one and the same. The variables have simply been rearranged to isolate the unknown. Unfortunately, if both correlation and covariance are unknown, then the equation is rendered useless. Therefore, an alternative equation must be used, one that is not predicated on the other, but on the periodic returns of each asset. The formula to solve for covariance if correlation is unknown is:



[[sigma].sub.ij] = Covariance of assets i,j

n = Number of Observations or Units

[r.sub.i] = Actual Return at each period "t"

[mu] = Average Return

The easier of these two statistics to interpret is the correlation coefficient, which scales covariance based on the product of the standard deviation of the two measured assets. The correlation coefficient is often denoted by the Greek letter rho ([rho]).

Correlation is measured on a scale of -1 to +1, with a value of zero indicating no relationship between two variables. If assets are positively correlated, it means that as one asset rises (falls) the other asset usually does the same. If the assets are negatively correlated, then as one asset rises the other asset falls, and as one asset falls the other asset rises. If assets are positively correlated to a degree of +1, meaning that they are perfectly correlated, then not only will both assets rise at the same time they will rise at the same rate. The inverse of this is also true, if the assets are perfectly inversely correlated (-1). The formula for correlation is:

[[rho].sub.i,j] = [[sigma].sub.j] /[[sigma].sub.i][[sigma].sub.j]

Standard Deviation of a Portfolio

Now that all of the statistics about Assets A and B are known, the power of investment statistics can be applied to a combination of these two assets--a portfolio. Unfortunately a financial planner cannot simply weight the asset standard deviations to calculate the portfolio standard deviation like what is done with returns. This cannot be done because it ignores the covariance of the assets when used in tandem. Therefore the following equation must be used to determine the standard deviation of a two asset portfolio.



[sigma] = Standard Deviation

w = Weight "allocation" of each asset

[[sigma].sub.ij] = Covariance

Portfolio Statistics--Using Probabilities

Expected Return

So far the statistics have been calculated based on historical--or known data. But as the investment disclaimer states, "past performance does not guarantee future results." In order for a financial planner to "plan," some assumptions about the future must be made. These assumptions become the basis for expectations.

To be compensated for a variety of risks, clients will expect a certain level of return. This "expected" return, denoted as E(r), can be mathematically calculated by adding the appropriate risk premiums to the risk free rate of return as follows.

E(r) = [r.sub.f] + IP + DP + BP + ...


E(r) = Expected return

[r.sub.f] = Risk-free rate

IP = Inflation Risk Premium

DP = Default Risk Premium

BP = Business Risk Premium

For simplicity, these risk premia are typically grouped together as one aggregated risk premium accounting for both systematic and unsystematic risks. Once an expected rate of return is calculated, it is important for a financial planner to determine if rates of return available in the marketplace are adequate for the level of risk that the client is willing to accept. Also, a financial planner must perform a sensitivity analysis to determine how likely the projected returns will occur.

Expected Return (using probabilities)

One of the most common tasks for a financial planner to complete for a client is a scenario analysis that looks at the possible outcomes under various market conditions. However, for ease of communication and explanation with the client, these scenarios can be aggregated into what is the most likely outcome--or at least an average representation of the scenarios.

Assigning and using probabilities is the easiest method to aggregate these outcomes. If a planner looks at three possible market conditions--Boom, Normal, and Bust--and assigns a probability to each outcome, then the planner can determine an "average" or most likely outcome.

Example: A planner determines that in any given year there is a 20% likelihood of above normal returns (Boom), a 65% chance of average returns (Normal), and a 15% possibility of below normal returns (Bust). The planner also determines that the corresponding returns would be 21%, 9%, and -12%, respectively. Knowing this information the planner can now calculate the most likely--or average--outcome to be 8.25% using the following formula.

E(r) = ([p.sub.1] [r.sub.1]) + ([p.sub.2] x [r.sub.2]) + ([p.sub.n-1] [r.sub.n-1]) + ... + ([P.sub.n]) x [r.sub.n]) Where:

E(r) = Expected return p = Probability of Outcome r = Return (outcome) n = Number of Outcomes

E(r) = (20% x 21%) + (65% x 9%) + (15% x -12%) = 8.25%

Standard Deviation and Confidence Levels

If returns are normally distributed, nearly 100% of all possible outcomes fall within 3 standard deviations above or below the mean. Therefore, a planner can reasonably predict the minimum and maximum periodic return value for any length of time.

Risk can be quantified using measures of volatility. Standard deviation is a measure of historical returns as they are dispersed around an average. Although a portfolio's standard deviation can change, planners usually assume that historical standard deviation is somewhat predictive of a portfolio's future volatility. To effectively use this measure of risk, a financial planner needs to understand the following confidence levels.

1. Approximately 68% of all observations fall within one standard deviation of the mean.

2. Approximately 95% of all observations fall within two standard deviations of the mean.

3. Approximately 99% of all observations fall within three standard deviations of the mean.

Example. A portfolio returned an average of 12% and the standard deviation was 15%. Applying the three confidence levels, a planner could be 68% confident that a client's actual returns fell within a range of -3% and 27% (12% +/- 15%). A 95% confidence level would suggest that returns ranged from -18% to 42% (12% +/- 30% (2 x 15%)) in any given year. A 99% confidence level suggests that returns ranged from -33% to 57% (12% +/- 45% (3 x 15%)) in any given year.

Standard deviation plays a central role in helping financial planners understand the dynamics of portfolio management issues. The measure of standard deviation, along with covariance and variance, makes up the core basis of modern portfolio theory.

Sensitivity Analysis: Capital Asset Pricing Model (CAPM)_

CAPM Expected Return

Once a financial planner knows the return of the market, the risk-free rate of return, and a portfolio's beta, the planner can calculate an expected riskadjusted rate of return for the portfolio. The formula used to calculate an expected rate of return is known as the Capital Asset Pricing Model (CAPM). The CAPM formula is shown below:

[R.sub.Exp] = [R.sub.f] + [beta]([R.sub.m]-[R.sub.f])


[R.sub.exp] = Expected Risk-Adjusted Rate of Return

[R.sub.f] = Risk-Free Rate

[beta] = Beta

[R.sub.m] = Return on the Market

The risk-free rate of return is most often indexed to Treasury bill rates, or other risk-free short-term rates. Some financial planners use the 10-year rate to approximate the long-term horizon assumed of a stock holding or the one-year rate as a proxy for a one-year forecast horizon. The return on the market used most often is the S&P 500 for domestic portfolios. However, other benchmarks can be used. For example, if a portfolio is comprised of technology and Internet stocks, the NASDAQ index may be an appropriate benchmark. A portfolio comprised primarily of non-U.S. stocks might be benchmarked against the Europe, Australia, and Far East (EAFE) index.

Example. Assume that Chris has a retirement portfolio that is well diversified. Over the past three years, the portfolio's beta was calculated to be 0.85. The risk-free rate at the time of the analysis was 3%, while the market returned 12%. What risk-adjusted return should Chris have received during the 3-year period?

CAPM Return = 0.03 + [0.85 x (0.12--0.03)] = 10.65%

This means that Chris should have received 10.65%, on a risk-adjusted basis, over the three year period. Anything below this expected rate of return would suggest that Chris took unsystematic market risk that Chris was not compensated for.


The primary weakness associated with measuring volatility using standard deviation is that it is security/portfolio specific. It is difficult to compare one portfolio against another using standard deviation. Many planners instead use beta as a measure of volatility to solve this problem. Beta is a relative measure of risk and is most often used as a measure of systematic risk in the stock market, but can also measure a portfolio's volatility compared to a market index.

Beta is generally estimated by using a linear regression for each asset, based on the historical asset returns and the corresponding market returns. Beta is sometimes estimated as:

[beta] = ([[sigma].sub.p]/[[sigma].sub.m]) x [[sigma].sub.p,m]


[[sigma].sub.p] = Standard Deviation of the Portfolio

[[sigma].sub.m] = Standard Deviation of the Market

[[rho].sub.p,m] = Correlation between Portfolio and Market

Example. Assume that the standard deviation of a portfolio of stocks is 14%, while the standard deviation of a market index, such as the S&P 500, is 12%. If the correlation between the portfolio and market is 0.90, the beta of the stock portfolio must be 1.05 [(0.14 -f 0.12) x 0.90].

The beta of the market is, by definition, 1.00. Most typically, the S&P 500 is used as the market index. A portfolio with a beta less than 1.00 is considered to be less volatile than the market. On the other hand, a beta greater than 1.00 implies volatility in excess of the market. Beta is useful because the number can be used to tell a client approximately how much less or more volatile a portfolio is compared to the market. A beta of 1.10 indicates, for example, that a portfolio is approximately 10% more volatile than the index. Beta coefficients are theoretically continuous, meaning that scores can range from less than zero to a positive number. In practice, however, beta coefficients for diversified portfolios rarely exceed 4.0 on the high or -2.0 on the low side.

Jensen's Alpha

Another useful statistic is alpha or the Jensen Performance Index. Alpha measures a portfolio's relative under- or over-performance compared to the market. Alpha measures the difference between a portfolio's actual returns and its expected risk-adjusted performance. The following formula is used to determine a portfolio's Jensen alpha:

[alpha] = [R.sub.p]-[[R.sub.f] + [beta]([R.sub.m]-[R.sub.f])]


[alpha] = Alpha

[R.sub.p] = Actual Return of the Portfolio

[R.sub.f] = Risk-Free Rate

[beta] = Beta

[R.sub.m] = Return on the Market

A positive alpha indicates that a portfolio exceeded expectations on a riskadjusted basis. A negative alpha suggests that a portfolio underperformed the market on a risk-adjusted basis. A reallocation of assets may be warranted if a portfolio shows a long history of significant underperformance.

Example. Returning to Chris's portfolio from the previous example; if Chris actually earned a rate of return of 12% over the three-year period, she would conclude that on a risk-adjusted basis she did better than expected. Her portfolio would have generated a positive alpha of 1.35% [12%--10.65%]. If the portfolio were managed by a professional money manager, one could conclude that the manager added value above what would have been expected give the risk taken.

Performance Measures--Applications of Investment Statistics_

Two performance measures are often used to determine the risk-adjusted performance of a portfolio: the Sharpe Ratio and the Treynor Index.

Sharpe Ratio

The Sharpe Ratio standardizes portfolio performance in excess of the riskfree rate by the standard deviation of the portfolio. Higher Sharpe Ratio scores are better. However, the ratio is not useful unless an investor has a comparable portfolio to judge the score against. The Sharpe Ratio can be calculated using the following formula:

[S.sub.i] = [R.sub.i] - [R.sub.f] / [[sigma].sub.i]


[S.sub.i] = Sharpe Ratio

[R.sub.i] = Actual Return of the Asset (or Portfolio)

[R.sub.f] = Risk-Free Rate

[[sigma].sub.i] = Standard Deviation of Asset (or Portfolio)

Example: Return to the earlier example for Asset A, with an average return of 3.88% and a standard deviation of 9.34%. Assume that the risk-free rate during the analysis period averaged 2%. The Sharpe Ratio for Asset A would be 0.2013 = [(0.0388--0.02) / 0.0934]. If there is an alternative investment with a Sharpe ratio of 0.50, it may be a wise choice to invest in the alternative because it would have a higher risk-adjusted return.

The Treynor Index is also a measure of standardized risk-adjusted performance. Instead of using standard deviation as a measure of absolute volatility, the formula uses beta as a measure of systematic risk. Just like the Sharpe Ratio, the Treynor Index number is only useful in terms of comparing one portfolio to another. A Treynor Index score can be calculated using the following formula:

[T.sub.i] = [R.sub.i] - [R.sub.f] /[[beta].sub.i]


[T.sub.i] = Treynor Index

[R.sub.p] = Actual Return of the Portfolio

[R.sub.f] = Risk-Free Rate

[beta] = Beta

Example. Assume Chris' portfolio return was 12%, the risk-fre rate was 3%, and Beta was 0.85. The Treynor Index for the portfolio is 0.106 [(0.12 - 0.03) / 0.85].

In some cases, the analysis may lead to quick and apparent conclusions. For example, a portfolio that carries a higher beta (risk), a lower annualized rate of return, and hence a lower alpha than the benchmark may lead to the conclusion that the client is taking too much risk for the return received. Therefore, the planner might recommend reallocating the portfolio.

However, not all analyses are that simple. During the early 2000s, for instance, portfolios that were over-weighted in bonds and cash tended to outperform portfolios that were more balanced. These fixed-income heavy portfolios almost always showed betas that were lower, alphas that were higher, and returns that were superior to balanced portfolio indexes. So, on paper, these portfolios looked better than what might actually be the case going forward. Over the long-run, remember, risk and return are positively related. In the shortterm, the relationship may not hold. To believe that risk and return would continue to be uncorrelated could lead to serious underachievement of client goals if and when the relationship reverted back to normal associations.

This is an example of a situation where a financial planner needs to evaluate a portfolio's characteristics using experience and skill. A client who should be taking a balanced growth investment approach should not allow the percent of assets held in any one asset class to dramatically exceed the benchmark level. If this occurs, the planner should again consider reallocating assets. If the current allocation is not changed, this would imply that either the client's goal(s) had changed or that the desired level of risk had changed. This might be the result of a change in economic expectations, risk capacity, or another factor.

Throughout the comprehensive financial planning process, including insurance, retirement, and special situation planning, it is essential that a planner know how a client's current assets are invested. A client's asset allocation strategy for each goal can tell a planner much about how well a client is progressing towards meeting certain objectives. Analytical tools can easily generate modern portfolio statistics that provide an insight into the relative position of a portfolio. Planners need to understand and be able to interpret these statistics for clients.


Review Prospective Investment Strategies

Clients tend to seek the help of a financial planner for investment planning guidance for one of three reasons: (1) they want to increase the capital appreciation potential of their investments; (2) they want to increase the amount of current income earned from their investments; or (3) they want to reduce the amount of taxes paid on their investments. However, clients are often unaware of what may be necessary to increase their real return, their risk-adjusted return, or their after-tax return. It is up to the planner to help the client understand about methods to measure returns and to determine a realistic return. In other words, it is the planner's job to manage the client's expectations. An experienced financial planner could also look for strategies that act as an inflation hedge or that reduce risk. The best planning strategies accomplish more than one objective, such as ones that hedge inflation and provide current income.

Identify Prospective Investment Management Strategies

Due to the wide variety of investment products available, there are an equally diverse number of strategies that can be used to meet client goals and objectives. While the tendency when dealing with investments is to focus on specific products, the procedure of investment planning can be just as important.

Take, for example, recommending the purchase of municipal bonds. This might be a great strategy for a client, unless it is poorly executed by purchasing the bonds within a tax-advantaged account. Because the rules for the IRA, or other tax-deferred account, determines whether a distribution is taxable or not, there is no benefit for earnings originally coming from tax-exempt interest. While there are no rules that prevent this investment strategy, the planner may be doing a client a great disservice by executing the strategy in this manner. Having a client double check the beneficiary on a retirement account, or retitling a mutual fund so that both spouses are on the account, are examples of procedural strategies.

Product Strategy 1: Use Zero Coupon Bonds if Anticipating Changes in Interest Rates

Advantage: Zero coupon bonds are purchased at a discount to their face value. These types of bonds pay no interest; instead, bond owners accrue interest over time. Zero coupon bonds are unique in that the bond's maturity and duration are basically the same.

This means that a bond with a maturity and duration of five years will typically move by 5% up or down with a 1% change in interest rates. Someone who believes that interest rates are going to fall can speculate on rising bond prices by purchasing long-maturity zero coupon bonds to obtain the maximum price appreciation. On the other hand, someone who believes that rates will move up could sell long-term zero coupon bonds and replace them with short-maturity bonds.

Disadvantage: Investors who use zero coupon bonds in their taxable portfolios need to be aware that, although they receive no income from the bonds, all accrued interest is taxable in the year of accrual. Any capital gains captured from this strategy will also result in a tax liability. Prices of zero coupon bonds are very sensitive to changes in interest rates.

Product Strategy 2: Adjust the Duration of Bond Portfolio if Anticipating Changes in Interest Rates

Advantage: The duration of a bond or bond portfolio tells an investor approximately how much a bond or portfolio will change in value in relation to a change in interest rates. A duration equal to 5 means that if interest rates increase by 1%, the bond will decline in value by 5%. If interest rates decline by 1%, the bond should increase by 5%.

Knowing this, an investor can adjust a bond portfolio's exposure to interest rate changes by adjusting duration. If a planner, for instance, believes that interest rates will fall, the planner could increase the duration of the bond portfolio to capture the increase in principal that should accompany the interest rate change. If, on the other hand, interest rates are expected to increase, the duration of the bond portfolio could be reduced.

Disadvantage: In general, this strategy is an effective way to reduce interest rate risk within a bond portfolio. However, duration can be misleading in certain situations.

For instance, the duration of a mortgage-backed security is often misleading. If rates rise, mortgage-backed bond prices will fall. If interest rates decline, these same bonds may not go up in value as much as their duration indicates. This is due to the fact that, as interest rates decline, home owners tend to refinance their mortgages, leading to prepayment of mortgage loan obligations. This effectively reduces the duration and potential capital gain advantage of mortgage-backed securities.

Product Strategy 3: Increase Client Income by Investing in Real Estate Investment Trusts (REITs)

Advantage: REITs are structured in a way that allows investors to pool their investments together in a publicly traded company that then purchases a portfolio of real estate. REITs can invest in land, buildings, shopping centers, apartment buildings, offices, and mortgages. REIT investments are attractive for income-oriented investors because REITs are required to distribute 90% of income received from rents, dividends, interest, and other gains, such as income from the sale of securities and property.

Disadvantage: Although REITs tend to be high-income producing investments, several factors can make these securities problematic for clients. First, real estate tends to be cyclical, and given that REITs may invest in local markets, rates-of-return earned on real estate assets will always be tied to local market conditions. There is no guarantee that currently high yields will persist into the future. Further, the lack of liquidity in the commercial real estate markets means that REITs carry more risk than other dividend paying stocks.

Product Strategy 4: Write (Sell) Covered Calls to Increase Portfolio Income

Advantage: Suppose that a client owns a stock that has appreciated in value. The client would like to sell the stock to capture the profit, but, at the same time, would not mind holding the stock if income could be generated from the asset. Writing a covered call could be a good strategy that achieves the client's objective.

Writing a call provides immediate premium income for the client, which effectively reduces the cost basis of the original stock. If the price of the stock goes up, the stock may be called away, but this results in generally the same outcome as selling the stock now. If the price of the stock should fall, the call option serves as a hedge, reducing or eliminating the loss on the stock price decline.

Disadvantage: Opportunity costs are linked with this strategy. If the price of the stock goes up dramatically, the client will lose both the stock and the price appreciation. If the client purchases back the option, the client will pay much more than the premium earned originally, which will result in a reduced gain.

Further, the commission associated with writing covered calls can be quite high, as a percent of assets, for those selling one or a few options. The strategy is only cost effective if large blocks of options are traded.

Product Strategy 5: Increase Portfolio Income by Reducing Bond Quality Mix in a Portfolio

Advantage: Due to the inverse relationship between bond quality and interest rate--the lower the grade, the higher the interest rate paid--clients who need additional income may want to include lower grade speculative bonds in their portfolios. One way to do this is through junk bond mutual funds. These funds provide diversification and professional management as a way to reduce the increased risk associated with this strategy.

Disadvantage: This strategy has many potential pitfalls. First, clients who purchase lower grade bonds, especially junk bonds, run the risk that the bonds will not be redeemed due to default. Also, lower grade bonds are more volatile whenever interest rates change. So, an increase in interest rates will result in a greater loss in value than a similar higher rated bond. Finally, junk bonds tend to trade more like stocks than bonds. This means that lower grade bonds are impacted by both a company's financial situation and interest rates, which subjects the bond holder to greater overall risk.

Product Strategy 6: Reduce Tax Costs by Investing in Dividend Paying Stocks

Advantage: Taxes on qualified stock dividends are capped at 15% for taxpayers in the 25% marginal tax rate and above, and 0% for taxpayers who are in lower marginal tax brackets. This means that clients who need income from their investments should consider shifting assets towards dividend paying stocks. The net after-tax yield, given the lower tax on dividends, means a higher return for clients.

Disadvantage: It is important to remember that some dividends from stock and bond mutual funds are not considered to be qualified for the lower tax rate.

In order to take advantage of this strategy, a client may need to build a diversified portfolio of individual stocks. This will mean potentially higher transaction costs, which for smaller portfolios, may negate the tax advantage of receiving dividends. Further, the costs, particularly in time, to manage a stock portfolio may not be worth the marginal tax benefit.

Product Strategy 7: Decrease Tax Liability by Investing in Municipal Securities

Advantage: One of the basic tenets of investing is that an analysis of tax-free yields compared to fully taxable yields should be conducted on a regular basis for those investing in fixed-income securities. Clients in the highest marginal tax brackets often find that municipal securities provide a higher after-tax return than similar fully taxable bonds, even if the initial yield is higher on the taxable bonds. The following formula can be used to determine whether owning a tax-free bond investment is better than owning a taxable security.

tax-free rate = taxable rate x (1-marginal tax bracket)

For example, assume that a client can earn 4% in a fully taxable bond fund and is in the 25% marginal federal tax bracket. The equivalent tax free rate is 3% [4% x (1-25%)]. The client would be just as well served by investing in a municipal bond fund with a yield of at least 3%.

This strategy is even more effective if a client purchases municipal securities from the state in which the client lives. In these cases, interest earned is usually both federal and state tax free.

Disadvantage: The primary disadvantage associated with this strategy is that sometimes a client will conduct a tax-equivalency calculation and determine that the relationship between taxable and tax-free rates is fixed. In fact, the relationship between rates can change frequently, meaning that this analysis should occur more frequently that it often does.

Also, clients need to be aware that municipal securities generally have a lower degree of liquidity and marketability than some corporate, and nearly all federal government, debt. The importance of assessing each credit agency's debt rating cannot be overemphasized.

Product Strategy 8: Invest in a Variable Annuity to Reduce Current Taxes

Advantage: Variable annuities provide clients with multiple advantages. Notably, annuities can be tax efficient. Dividends, interest, and capital gains earned in any given year are deferred until a later date. This can be quite beneficial for clients who will be in a lower marginal tax bracket in retirement than today, and for those clients who employ tactical asset allocation strategies resulting in many trades.

Disadvantage: Variable annuity products should only be used in situations where a client has a long-term investment horizon. This strategy is not appropriate for clients who will need assets to fund expenses, such as the purchase of a home, car, or business. Some variable annuity products can be quite expensive. Further, income distributions are taxed at the client's full marginal income tax bracket.

Product Strategy 9: Hedge Inflation in a Fixed-Income Portfolio with Treasury Inflation-Indexed Securities

Advantage: Treasury Inflation-Protection Securities (TIPS) are 10-year bonds issued by the federal government. Purchasing TIPS is a strategy designed to reduce inflation risk. The principal value of a TIPS is adjusted on a semi-annual basis to account for inflation, as measured by the consumer price index. At maturity, the redemption price is equal to the greater of the inflation-adjusted principal amount or par value. The coupon rate for TIPS is fixed, but payments to bond holders can increase over time as the inflation-adjusted principal amount increases.

Disadvantage: Several potential disadvantages are associated with TIPS. First, the initial coupon rate for new issues is significantly less than yields on comparable non-inflation adjusted debt. This means that, if inflation stays quiescent or there is deflation, the bond holder will receive less annual income than other investors. Second, bond holders must pay taxes on the increase in the inflation-adjusted principal amount on a yearly basis, not at maturity. This is the reason why TIPS make most sense in tax-deferred portfolios.

Product Strategy 10: Hedge a Portfolio against Inflation with Hard Assets and Precious Metals

Advantage: During times of high inflation, hard assets and precious metals tend to outperform other assets, especially fixed-income and equity assets. There are many reasons for this, but, in general, the limited supply of these assets makes them an attractive alternative to other securities during inflationary times.

Disadvantage: The disadvantages associated with this strategy may offset the advantages provided by holding hard assets. First, hard assets and precious metals entail holding costs that can be substantial. A place needs to be devoted to holding the physical assets, and insurance may need to be purchased to guard the value in case of loss or theft. All of these costs work to erode the gain potential offered by the strategy.

Also, values of hard assets and precious metals are determined primarily by supply and demand factors. If new supply enters the market, the value of the assets is almost sure to fall. When inflation becomes less of a factor, the value of hard assets will tend to stagnate or fall.

Product Strategy 11: Protect a Client Against Interest Rate Risks by Creating a Laddered FixedIncome Portfolio

Advantage: Clients often want to limit the maturity and duration of a fixedincome portfolio to reduce interest rate risk. Unfortunately, doing so will usually reduce the level of income generated from the portfolio. One strategy to increase the average yield on a portfolio of fixed-income securities while limiting average portfolio maturity involves creating a ladder.

Using Certificates of Deposit (CDs), for instance, a client could purchase equal dollar amounts of 3-, 6-, 9-, and 12-month CDs. Whenever one CD matures, another 12-month CD would be purchased. This plan provides a weighted average maturity of less than 12-months, but a yield greater than that offered on a 3-month CD. Further, this strategy increases a client's liquidity situation, because there is always a CD near maturity. Obviously, the strategy could be extended beyond 12-months by adding CDs with longer maturities. The same strategy can be used to develop bond portfolios.

Disadvantage: While this strategy is relatively simple to implement, it does require constant monitoring to remain effective. New securities need to be purchased on a regular basis. This makes the analysis of the fixed-income market extremely important. Replacing securities that mature with assets of similar credit quality and yields will require more work than simply buying and holding one or a few securities.

Product Strategy 12: Purchase Rental Real Estate to Reduce Taxes and Generate Cash Flow

Advantage: A client's comfort level, knowledge, and experience with certain types of investments will often dictate which strategy will dominate an investment plan. Some clients will prefer to invest directly in real estate, rather than through stocks, bonds, and other investment assets. Rental real estate can provide clients with deferred capital gains, tax shelter, an inflation hedge, and cash flow.

Disadvantage: Lack of liquidity and potential limited marketability are two significant disadvantages associated with this strategy. Clients who are considering rental real estate need to also remember that costs for ongoing operating expenses can sometimes escalate faster than rents in certain locations. This is especially true in cases where the client hires a management firm to handle all aspects of rental ownership.

Another disadvantage associated with real estate investing is that it requires the temperament and skill of a trained property manager to consistently make money. For example, client owners of rental properties need to sometimes be a plumber, electrician, painter, sales agent, and evictor. Not everyone is capable of doing these activities. It may be possible to hire a management firm to oversee properties, but the costs associated with management may erode the return on investment generated from a property.

Procedural Strategy 1: Balance Long- and Short-Term Tax Gain and Loss Selling to Maximum Tax Savings

Advantage: This strategy is premised on the fact that only $3,000 in short-term losses can be used to offset regular income in any given year. If a client has more short-term losses than short- and long-term gains, these losses need to be carried forward into future years. By matching investment losses with asset gains, it may be possible to minimize the negative impact of taxes on portfolio performance.

Disadvantage: It may not always be possible to match losses and gains. It may be better to take a short-term loss than to wait and potentially have the investment liquidated with no value at all.

Procedural Strategy 2: Reallocate the Current Portfolio to Match the Client's Changing Investment Profile

Advantage: Reallocating portfolio assets can be counted as one of the most basic investment planning strategies available. Because risk and return are positively related, it is reasonable to assume that, over time, a portfolio that is invested more aggressively should outperform other less risky portfolios. However, as a client's time horizon, risk tolerance, or risk capacity change, the investment allocation should also change.

Disadvantage: Although this is an easy recommendation to make, actual implementation entails many pitfalls. For example, reallocating assets through sales of existing assets and purchases of new assets will result in tax implications, as well as certain up-front costs. Also, it is unreasonable to assume that asset returns will improve in the short-term simply by taking more risk. This relationship holds true only over extended periods of time.

Procedural Strategy 3: Invest in Low Cost Mutual Funds to Maximize Performance

Advantage: Mutual funds represent the most widely used investment company product. Mutual funds are professionally managed pooled asset investment companies that are formed to meet a specific investment objective. In effect, mutual funds pool assets from a number of investors, and the mutual fund hires a portfolio manager who uses the assets to purchase stocks, bonds, or other assets.

Mutual funds are an attractive investment choice for clients, because funds tend to provide diversification and relatively low costs. Additionally, mutual funds provide investors of modest means access to professional management at very reasonable entry levels. Shares in some funds can be purchased

for as little as $100.

The most useful predictor of a funds future performance is the expense ratio. Funds with lower expense ratios historically and empirically tend to outperform others.

Disadvantage: Choosing low cost mutual funds is an easy prescription, but sometimes a difficult process. There may be situations where a low cost mutual fund is unavailable. In these cases, other determinants of mutual fund performance should be used to screen potential fund investments.

Procedural Strategy 4: Consider Adding Exchange Traded Funds to Client Portfolios

Advantage: Exchange Traded Funds (ETFs) are emerging as a popular investment company product. Unlike traditional mutual funds, ETFs can be traded throughout the day, similarly to a stock, bond, or option. This gives ETFs a unique advantage over funds, while retaining most of the attributes offered by mutual funds.

Exchange Traded Funds are distinguishable from mutual funds in two respects. First, very few ETFs are actively managed. Until recently, nearly all ETFs mimicked a market index, such as the S&P 500, Dow Jones Industrial Average, or other market indices. Second, investment companies develop ETFs by using Creation Units, which are then pooled into baskets of securities. These baskets of securities mirror the underlying index, and it is these securities which are bought and sold by investors. This allows an investor to purchase one or more units of an ETF, and when an ETF investor wishes to sell their investment they can either sell units to other investors on the secondary market, or they can sell the units back to the investment company, though this is rarely done.

An ETF investment strategy provides investors with multiple advantages. In general, ETFs allow clients to develop well diversified portfolios with low annual expenses. ETFs also offer liquidity and marketability to a greater extent than index mutual funds. Moreover, ETFs are completely transparent, which means that the exact components and weightings of securities held in the portfolios are always known. Mutual funds, on the other hand, are only partially transparent, because they only have to make their holdings known on a periodic basis and, even then, they are allowed to delay the publication of the data for a certain period of time to protect their marketability.

Other ETF advantages include tax efficiency and investment style stability. ETFs are tax efficient because portfolio turnover is low or even zero, which results in few taxable distributions. ETFs also allow financial planners to develop portfolios with fixed allocations to certain market benchmarks. Unlike mutual funds that tend to exhibit style drift, investing via an ETF almost guarantees exposure to a chosen asset class and market.

Disadvantage: The primary disadvantage associated with ETFs is the lack of active management. Once an ETF is created, the underlying assets do not change. This means that the opportunity to outperform the market, on a risk-adjusted basis, is very low. Also, because ETFs are traded like stocks, clients will incur trading commissions whenever shares are bought and sold.

Chapter-Based Case Study

A Client-Based Investments Recommendation Example_

There are many investment planning strategies available to help clients achieve their financial goals. The ones identified above are just a sampling of the alternatives available. For clients with more specialized needs (e.g., high net worth, business owners, extended families, etc.), the number, type, and complexity of strategies becomes even larger. What is really important when molding strategies into specific client recommendations is to remember that the client's goals should dominate the process.

Planners and clients often find that the simplest strategy is the one that makes the best recommendation. The temptation is to attempt to develop very complex and intricate recommendations. This is not always appropriate or even necessary.

The average client simply needs guidance answering one of three core investment questions. How can I increase my rate-of-return? How can I maintain my current level of wealth? How can I generate more income from my assets? While answers to these questions can be complex, depending on the client situation, many solutions are quite easy to understand and implement.

In many ways, the development and presentation of investment planning recommendations is the most important part of financial planning. Lack of implementation by the client is the leading cause of plan failure. As such, it is imperative that recommendations be easily understood, conceptually valid, and cost effective.

For the majority of investment planning recommendations, any prudent person should be able to quickly understand the reasoning behind the recommendation and the potential outcomes associated with implementation. This all means that answers to the core issues of--who, what, when, where, why, how, and how much--ought to be clear, concise, and understandable. However, planners should always solicit client collaboration in the decision making and the implementation, depending on the extent of the planner-client engagement. No client wants to be pushed into accepting a recommendation that is not fully explained, no matter how concise, well-intentioned, or suitable it may be.

The issue of fiduciary responsibility is one of significant importance for planners who offer investment planning services. Documenting that certain records have been obtained from a client and showing that important information has been shared with clients is an important first step in the recommendation, development, and implementation process.

A Sample Recommendation: Reallocate a Portfolio. for Changing Economic Conditions_

The primary purpose of investment planning is to determine if a client's current portfolio situation is suitable, reasonable, and appropriate for a given financial goal or objective. This scenario considers Tobias Fleischer, a middle-aged, married father of one son. Tobias has recently realized that his retirement account that performed so admirably several years ago is no longer keeping up with the market.

During the first meeting, the planner had Tobias complete a risk tolerance questionnaire and provide some basic information about his finances. The planner drew up forms showing Tobias' Financial Ratios and Tobias' Investment Profile and Portfolio Summary.

The planner made a number of conclusions. Tobias's quantitative and qualitative investment profile is squarely in the moderate risk area and his stated investment objective is capital appreciation for retirement. Taxes are not a concern, because the portfolio in question is in a 401(k) account. For the qualitative measures, Tobias's risk tolerance and knowledge level are moderate, which suggests that he should be able to withstand, as well as understand, a reasonable level of portfolio volatility. Furthermore, he has positive expectations about future market prospects. This positive outlook is also indicative of an investor that would be willing to experience some short-term volatility for the potential benefit of achieving superior long-term gains.

In terms of socioeconomic descriptors, Tobias' time horizon for goal achievement is long-term, over 10 years, and his risk capacity is moderate. His planner reasonably assigned this risk capacity ranking because the financial ratios indicate that Tobias is solvent, has a funded emergency savings account, and has positive savings ratios. The only point of concern is his debt level.

Both the debt ratio and the long-term debt coverage ratio only marginally meet industry benchmarks. This may mean that his planner should review some additional debt reduction strategies prior to reallocating the portfolio. However, because Tobias is solvent, meaning that there are enough assets to pay-off all debt, Tobias' planner simply confirmed his comfort with the existing level of debt and continued with the reallocation recommendation.

Therefore, both quantitative measures support the notion that Tobias is willing and able to be more aggressive with his investment allocation approach. In other words, Tobias is psychologically and fiscally capable to take on additional risk in order to achieve a higher rate of return to meet the financial goal. Given this information, it is likely that his planner could assign Tobias somewhere between a moderate and an above-average risk profile.

Situational factors, reflecting both qualitative and quantitative information obtained by Tobias' planner provides a framework for an analysis of the current portfolio. Current portfolio statistics are shown in the column titled "Current Statistics." Because Tobias's risk profile is moderate, the selected benchmark is a moderate growth portfolio. Statistics for the benchmark portfolio are shown in the column titled "Benchmark Statistics."

After entering the data, a planner would first notice that the beta, alpha, mean returns, and the Sharpe and Treynor indices of Tobias' original portfolio exceed the benchmark. This is reasonable, because the risk, as measured by beta, is lower, resulting in higher risk-adjusted returns. On the surface, it appears that the current portfolio is working quite well for Tobias. This is a case, however, where modern portfolio statistics can lead to a biased conclusion regarding the match between Tobias's investment profile and the appropriateness of the portfolio.

Looking further, Tobias' financial planner would quickly notice that Tobias' current asset allocation (Figure 10.5) does not match the selected benchmark, meaning that the client did not maximize his investment allocation. In this case, Tobias would probably miss-out on future market returns and have almost no chance at beating inflation with a 70% cash {position. The current portfolio also does not match the stated objective of capital appreciation. The current allocation would be more appropriate for a client with a current income or capital preservation goal.

Armed with the knowledge of Tobias' risk profile and his current portfolio allocation, the planner's recommendation should be that the portfolio needs to be reallocated (Figure 10.7). However, one objection the planner may need to overcome is that the current portfolio has recently outperformed the market. Tobias may not fully understand why this happened or why it is unlikely to continue.

The question that needs to be addressed when analyzing this portfolio is whether the conditions will persist into the future. According to the information provided by the client to generate the investment risk profile, the answer is no. Both Tobias and his planner expect the equity market situation to continue improving.

It is this belief, which is a very qualitative, yet important situational factor, that experienced financial planners would most often use as the basis of their portfolio recommendation. An improving economic situation, given the client's time horizon, risk tolerance, positive attitudes, and risk capacity, suggests that holding 70% of the portfolio in cash will lead to future underperformance. Tobias' investment risk profile exceeds the portfolio's actual risk level, so unless the client and planner change their economic outlook, this portfolio should be assessed as inappropriate for the goal and reallocated. Stated another way, the client's investment profile indicates that he should take more risk to earn higher potential future returns.

It is important that the key questions of implementation be addressed in relation to reallocating portfolio assets. Making a reallocation recommendation easy to understand and implement is important. If a client's questions and objections are not addressed, there is the possibility that action will not be taken. The Recommendation Form can be used to summarizS this investment planning recommendation. The form summarizes and codifies the reallocation recommendation, provides a cost estimate associated with implementation, a benefit statement, and specific implementation procedures relating to whom should reallocate the assets, when the action should be taken, and how implementation should take place.

The outcomes briefly noted above in the Recommendation Form indicate that implementation of this recommendation may have impacts on other parts of the financial plan, in this case, estate planning for their minor child. Documenting these impacts when the actual plan is being written, for reference later, is an important step in the recommendation and implementation phase of the investment planning process.

Investment planning recommendations, more so than nearly any other recommendations a planner can make, have the potential to significantly impact other parts of the financial plan. This is particularly true because the achievement of financial goals is also closely tied to the performance of a client's portfolio. So, depending on the situation, be it retirement planning, education funding, or special needs planning, the impact of a recommendation to reallocate assets can be significant.

Finally, because the account that is being reallocated is a tax-qualified retirement account, the proper ownership and beneficiary titling is paramount to successful implementation.

Additional Resources

Leimberg et al, The Tools and Techniques of Investment Planning, 2nd Edition (Cincinnati, OH: National Underwriter Company, 2006).

A risk-tolerance quiz is available on the CD.

Ellis, C.D. Investment Policy: How to Win the Loser's Game (New York: McGraw-Hill, 1993).

Guy, J.W. How to Invest Someone Else's Money (Chicago: Irwin, 1994).

Irwin, Albright, & Taylor, The Management of Investment Decisions (Chicago: Irwin, 1996).

NASD Mutual Fund Expense Analyzer: Information/Tools/Calculators/FundCalc/expense_analyzers.asp

Quantitative / Analytical Mini-Case Problems

1. Use the information provided in table below to calculate the weighted average before- and after-tax rate of return of the portfolio.
                                           Rate of
Asset    Allocation          Amount        Before Tax   After Tax

Fund A   Large Growth        $ 75,000.00    9.00%       6.75%
Fund B   Mid Value           $100,000.00    8.00%       6.00%
Fund C   Money Market        $ 94,000.00    2.00%       1.50%
Fund D   Small Growth        $ 14,000.00   12.00%       9.00%
Fund E   Small Value         $ 35,000.00    4.00%       3.00%
Fund F   High Quality Bond   $ 45,000.00    3.00%       2.25%
Fund G   Low Quality Bond    $112,000.00    5.00%       3.75%

2. Use the information shown in the following table to calculate the statistics below.
        Portfolio    Market
Year    Return       Return

1       12.00%        9.00%
2        9.00%        8.00%
3       22.00%       19.00%
4       -4.00%       -1.00%
5        2.00%        5.00%
6       25.00%       19.00%
7       15.00%       15.00%
8       -6.00%       -4.00%
9       11.00%        9.00%

a. Geometric Average of Portfolio and Market

b. Arithmetic Average of Portfolio and Market

c. Standard Deviation of Portfolio and Market

Comprehensive Bedo Case--Analysis Questions

Almost all of the Bedos' goals have an investment component. For example, saving for retirement, college, and a home addition all require the analysis of investment planning factors. Each investment-funded goal will require documentation of the Bedos' time horizon, risk tolerance, and investment attitudes for the goal--which might include investment restrictions imposed by the clients, expectations about the future, and risk capacity.

Furthermore, these facts may differ for each goal. For instance, the maximum amount of risk that the Bedos are comfortable taking for retirement may be different than the level of risk they are prepared to take with Becky's education funding. Thus, it will be important to review the client information as well as relevant assumptions, tax rates, and the Bedos' global asset allocation structure.

Note: Sufficient information is not yet available to quantify the education planning need or the retirement planning needs for the Bedos; thus all references to these goals, as relates to investment planning, will have to be addressed in generalities, with the integration of the investment strategies for the education planning and retirement planning more fully resolved in Chapters 11 and 12, respectively.

1. Develop a list of investment-funded planning goals (e.g., emergency fund situation, retirement investment plan, education funding goal, and the art gallery and home improvement goals) for the Bedos. When conceptualizing these goals, consider the following.

a. Is each goal developed in agreement with any or all goals and objectives that the clients have identified regarding investment planning?

b. What situational factors might influence their investment-funded goals (e.g., emergency fund situation, retirement investment plan, education funding goal, and the art gallery and home improvement goals)? Are these factors explicit, implied, or assumed? Is additional information required from the Bedos?

c. What is the desired outcome for the clients for each of these goals?

2. Make a list of life events that may impact these goals for Tyler and Mia and should be reviewed at future client meetings. Some events may affect all of the goals, while others may only affect selected goals.

3. Develop a list of globally-accepted, client-specific, or planner-generated planning assumptions that will structure the situational analysis and planning for each goal.

4. Summarize the Bedos' time horizon, risk tolerance, investment attitudes, economic expectations, and risk capacity for each of their investment-funded goals (e.g., emergency fund situation, retirement investment plan, education funding goal, and the art gallery and home improvement goals).

5. Summarize your observations about Tyler's and Mia's current planning efforts and the identified planning need(s) for each of the investment-funded goals (e.g., emergency fund situation, retirement investment plan, education funding goal, and the art gallery and home improvement goals). Complete an Investment Profile and Portfolio Summary Form for each goal to determine if changes are needed. Incorporate text, bullets, and graphics in your explanation. For example, what information might be shown graphically, and specifically what kind of graphs might most effectively convey the analysis to the Bedos?

6. Based on the goals originally identified and the completed analysis, what product or procedural strategies might be most useful to satisfy the Bedos' planning need(s) for each of the investment-funded goals (e.g., emergency fund situation, retirement investment plan, education funding goal, and the art gallery and home improvement goals)? Be sure to consider strategies matched to the planning needs identified. When reviewing the strategies, be careful to consider an approximate cost of implementation as well as the most likely outcome(s) associated with each strategy.

7. Write at least one primary and, if applicable, one alternative recommendation from the selected strategies in response to each identified planning need for the investment-funded goals (e.g., emergency fund situation, retirement investment plan, education funding goal, and the art gallery and home improvement goals). Include specific, defensible answers to the who, what, when, where, why, how, and how much implementation questions for each recommendation.

a. It is suggested that each recommendation be summarized in a Recommendation Form.

b. Assign a priority to each recommendation based on the likelihood of meeting client goals and desired outcomes. This priority will be important when recommendations from other core planning content areas are considered relative to the available discretionary funds for subsidizing all recommendations.

c. Comment briefly on the outcomes associated with each recommendation.

8. Dependent on the organization of the plan, a comprehensive plan may or may not include a section on investment planning. The section may be included and address all investment-funded goals, or the investment planning information may be included within the section corresponding to the individual goal (e.g., education planning or retirement planning). Given these options, choose one approach and complete the following for the Bedos' financial plan.

a. Outline the content to be included in the section of the plan. Given the segments written above and/or elsewhere in other chapters related specifically to the investment-funded goals, what segments are missing?

b. If applicable, write the introduction to this section of the plan (no more than 1 to 2 paragraphs).

c. Define, explain or interpret at least five terms or related to investment planning. For each, write a definition or explanation that could appear in a section of the plan or in the plan glossary.

Financial Computation Tip: Beta and Diversified Portfolios

One note of caution is in order in relation to beta. Planners who use beta should only do so with well diversified portfolios. Beta becomes very unstable and unreliable when used with single securities or non-diversified portfolios. In these cases, it is often best to use standard deviation as the measure of portfolio risk.

Financial Computation Tip: Standardized Risk and Return Measures

It is possible to standardize the risk-adjusted return of portfolios and securities to make comparison between and among portfolios more useful. The Treynor Index standardizes a portfolio's return in excess of the risk-free return by dividing the difference between the portfolio's return less the return of the market by beta [([R.sub.p]][R.sub.f])/[beta]. The Treynor Index should only be used to compare fully diversified portfolios. The Sharpe Index can be used, even if the portfolio is not well diversified, to standardize the return of a portfolio in excess of the risk-free return by using standard deviation as the divisor beta [([R.sub.p]-[R.sub.f])/[sisgma]].
Portfolio Risk Guidelines Based on Client Time Horizon and Risk

                   High Risk              Moderate Risk
Time Frame         Tolerance              Tolerance

10+Years           Aggressive             Mod. Aggressive
7 to 10 Years      Mod. Aggressive        Moderate
3 to 7 Years       Moderate               Moderate
1 to 3 Years       Mod. Conservative      Mod. Conservative
Less than 1 Year   Conservative           Conservative

Time Frame         Low Risk Tolerance

10+Years           Moderate
7 to 10 Years      Moderate
3 to 7 Years       Mod. Conservative
1 to 3 Years       Conservative
Less than 1 Year   Conservative

U.S. Annual Inflation Rates (1988 - 2007)

Year         Inflation Rate

1988              4.4%
1989              4.6%
1990              6.1%
1991              3.1%
1992              2.9%
1993              2.7%
1994              2.7%
1995              2.5%
1996              3.3%
1996              1.7%
1998              1.6%
1999              2.7%
2000              3.4%
2001              1.6%
2002              2.4%
2003              1.9%
2004              3.3%
2005              3.4%
2006              2.5%
2007              4.1%

Annual inflation rates are calculated based on changes in the
Consumer Price Index as available from the Bureau of Labor

ETFs Compared to Mutual Funds

Investment Attribute             ETF               Index Fund

Tradability                Can trade during    Can trade one-time
                             market hours           per day
Ability to Sell Short            Yes                   No
Transparency                     High           Moderate to High
Diversification              Low to High        Moderate to High
Tax Efficiency                Very High               High
Subject to Style Drift           Low                  Low

Investment Attribute         Managed Fund

Tradability               Can trade one-time
                               per day
Ability to Sell Short             No
Transparency               Low to Moderate
Diversification              Low to High
Tax Efficiency               Low to High
Subject to Style Drift       Low to High

Tobias' Financial Ratios

Ratio                           Client Outcome       Benchmark

Current Ratio                        1.10             > 1.00
Emergency Fund Ratio               9 months         3-6 months
Debt Ratio                            38%              < 40%
Savings Ratio                         5%               > 10%
Long-Term Debt Coverage Ratio        2.35             > 2.50

Tobias' Investment Profile and Portfolio Summary Form

Client Investment Profile

Qualitative                 Circle the appropriate response.

Risk Tolerance                   High            Moderate
Knowledge/Experience             High            Moderate
Market Expectations            Positive           Neutral


Time Horizon                     Long          Intermediate
Risk Capacity                    High            Moderate
Client Risk Profile *          Moderate           Client
                                                Profile **

Portfolio Measures             Current          Benchmark
                              Statistics        Statistics

Targeted Portfolio          Moderate Growth   Moderate Growth
Allocation Profile **

Observed Portfolio           Conservative           NA
Allocation Profile **           Growth

Portfolio Statistics ***

Beta                             0.11              0.85
Alpha                            1.59              1.32
[R.sup.2]                       30.00             84.00
Sharpe Ratio                     0.83              0.34
Treynor Ratio                   36.81              5.87

Fixed Income Measures

Bond Duration                    2.90              4.20
Average Bond Quality              AA                AA

Asset Allocation (%)

Cash                            70.00%             7.00%
U.S. Stock                      18.00%            52.00%
Foreign Stock                    5.00%            10.00%
Bond                             7.00%            27.00%
Other                            0.00%             4.00%

Sensitivity Analysis

3-year Average Return            5.15%             4.33%
Worst 1-year Loss               -2.58%           -10.60%
Best 1-year Gain                13.82%            25.33%
Does Portfolio Match         Yes        No    Yes         No
Investment Profile?                     X     X

Client Investment Profile

                                 Circle the
Qualitative                 appropriate response.

Risk Tolerance                      Low
Knowledge/Experience                Low
Market Expectations               Negative


Time Horizon                       Short
Risk Capacity                       Low
Client Risk Profile *         Moderate Growth

Portfolio Measures             Comparison to

Targeted Portfolio
Allocation Profile **

Observed Portfolio                 Lower
Allocation Profile **

Portfolio Statistics ***

Beta                               Lower
Alpha                              Higher
[R.sup.2]                          Lower
Sharpe Ratio                       Higher
Treynor Ratio                      Higher

Fixed Income Measures

Bond Duration                      Lower
Average Bond Quality                Same

Asset Allocation (%)

Cash                               Higher
U.S. Stock                         Lower
Foreign Stock                      Lower
Bond                               Lower
Other                              Lower

Sensitivity Analysis

3-year Average Return              Higher
Worst 1-year Loss                  Higher
Best 1-year Gain                   Lower
Does Portfolio Match
Investment Profile?

* Scale: (5: High, 4: Above average, 3: Moderate, 2: Below
Average, 1: Low)

** Scale: (6: Aggressive Growth, 5: Growth, 4: Moderate Growth,
3: Balanced Growth, 2: Conservative Growth, 1: Income)

*** Portfolio statistics compared to a broad-based market index

Planning Recommendation Form

Financial Planning          Investment Planning
Content Area

Client Goal                 Reallocate Portfolio to Obtain Higher
                            Long-Term Returns

Recommendation #: 1         Priority (1 - 6) lowest to highest:   6

Projected/Target            8.50% to 10.25% RoR
Value ($)

Product Profile

Type                        Qualified Retirement Account

Duration                    15+ Years

Provider                    Lindsey, Graham and Associates Planning,
                            using various investment companies as
                            itemized below.

Funding Cost per            Estimated transaction costs $1,200
Period ($)                  (includes transfer fees, account
                            maintenance fees, and CDSCs)

Maintenance Cost per        $0
Period ($)

Current Income Tax Status   Tax-Qualified      X      Taxable

Projected Rate of Return    8.50% to 10.25%

Major Policy Provisions     See Implementation Procedure

Procedural Factors

Implementation by Whom      Planner            X      Client

Implementation Date or      Immediately
Time Frame

Implementation Procedure    Reallocation of funds can be implemented
                            either by client or planner; if planner
                            implemented, client will need to
                            provide written acceptance of strategy.
                            The specific reallocation procedure
                            is as follows:

                            1. Reduce cash position by 58%

                            2. Allocate 37% of cash into the
                            following equity funds:

                            a. (12%) Germain and Lukajic Stock Fund

                            b. (12%) DuPaul, Batteman, and Bull
                            Growth Fund c. (13%) Coombs, Flaman,
                            and Hanchuck Small-cap Fund

                            3. Sell current bond fund and reallocate
                            an additional 6% of cash into the Jobin
                            and Dora Bond Fund

                            4. Use 5% of cash to increase holdings
                            in the foreign stock fund from 5% to
                            10% of assets

                            Reallocate 5% of assets from cash to the
                            Arbinger REIT Fund--a specialized real
                            estate trust

Ownership Factors

Owner(s)                    Tobias Fleischer

Form of Ownership           Sole Owner

Insured(s)                  NA

Custodial Account           Yes          No          X


In Trust For (ITF)          Yes          No          X

Transfer On Death (TOD)     Yes          No          X

Beneficiary(ies)            Agathe Fleischer (Wife)

Contingent                  Adam Fleischer (Son) via testamentary
Beneficiary(ies)            trust w/trustee named in will

Proposed Benefit            1. Should result in an increase total
                            risk-adjusted rate of return over
                            the next 10 years.

                            2. Should reduce income earned within the
                            account by an estimated $300 per year.

                            3. Although the income earned is not
                            taxable, the change in allocation is
                            more in keeping with capital appreciation

Figure 10.2 Examples of Expectation and Satisfaction Questions

1. Over the next five years, do you expect the U.S. economy, as a
whole, to perform better, worse, or about the same as it has over
the past five years?

a. Perform Better

b. Perform Worse

c. Perform About the Same

2. How satisfied are you with your current level of income?

1   2   3   4   5   6   7   8   9   10

Lowest Level Highest Level

3. How satisfied are you with your present overall financial

1   2   3   4   5   6   7   8   9   10

Lowest Level Highest Level

4. Overall, how satisfied are you with your current job or position
within your chosen career?

1   2   3   4   5   6   7   8   9   10

Lowest Level Highest Level

5. Rate yourself on your level of knowledge about personal finance
issues and investing.

1   2   3   4   5   6   7   8   9   10

Lowest Level Highest Level

Source: The Federal Reserve Board's Biannual Survey of Consumer

Figure 10.4 A Summery of Investment Characteristics by Investment

                                Risk (Aggressiveness)

Asset                        Liquidity        Marketability

Direct Investment

Cash                            High               High
Savings accounts                High               High
Certificates of deposit       Moderate             High
Treasury bills                  High               High
Treasury bonds                  High               High
EE and I savings bonds          High               High
HH savings bonds                High               High
GNMA and federal                High               High
  agency bonds
Municipal bonds               Moderate           Moderate
Investment grade              Moderate             High
  corporate bonds
Speculative grade             Moderate           Moderate
  corporate bonds
Zero coupon bonds             Moderate           Moderate
Preferred stock               Moderate       Moderate to High
Common stock              Moderate to High         High
Collectibles (coins,            Low          Low to moderate
  stamps, art, etc.)
Precious metals           Low to moderate        Moderate
Real estate                     Low                Low

Indirect Investment

Money market funds              High               High
Bond funds / ETFs               High               High
Stock funds / ETFs              High               High
Commodity funds           Moderate to High   Moderate to High
Real estate investment    Moderate to High   Moderate to High
  trusts (REITs)

Derivative Investment

Options and Warrants            Low          Low to Moderate
Futures                         Low                High

                          (Aggressiveness)    Potential Return

Asset                           Risk           Current Income

Direct Investment

Cash                             Low                 Low
Savings accounts                 Low                 Low
Certificates of deposit          Low                None
Treasury bills                   Low                None
Treasury bonds                   Low           Low to average
EE and I savings bonds           Low                None
HH savings bonds                 Low           Low to average
GNMA and federal                 Low               Average
  agency bonds
Municipal bonds               Moderate             Average
Investment grade              Moderate             Average
  corporate bonds
Speculative grade             Moderate              High
  corporate bonds
Zero coupon bonds             Moderate              None
Preferred stock               Moderate         Average to high
Common stock              Moderate to High     Low to average
Collectibles (coins,            High                None
  stamps, art, etc.)
Precious metals           Moderate to High          None
Real estate                     High             Low to high

Indirect Investment

Money market funds               Low           Low to average
Bond funds / ETFs                Low           Average to high
Stock funds / ETFs            Moderate         Low to average
Commodity funds                 High           Low to average
Real estate investment          High           Average to high
  trusts (REITs)

Derivative Investment

Options and Warrants            High           None to average
Futures                         High                None

                                 Potential Return

Asset                         Capital Appreciation *

Direct Investment

Cash                                   None
Savings accounts                       None
Certificates of deposit           Low to average
Treasury bills                    Low to average
Treasury bonds                    Low to average
EE and I savings bonds            Low to average
HH savings bonds                       None
GNMA and federal                      Average
  agency bonds
Municipal bonds                       Average
Investment grade                        Low
  corporate bonds
Speculative grade                   Low to high
  corporate bonds
Zero coupon bonds                 Average to high
Preferred stock                     None to low
Common stock                        Low to high
Collectibles (coins,      Dependent on supply and demand
  stamps, art, etc.)
Precious metals           Dependent on supply and demand
Real estate               Dependent on supply and demand

Indirect Investment

Money market funds                     None
Bond funds / ETFs                 Low to average
Stock funds / ETFs                Average to high
Commodity funds                     Low to high
Real estate investment            Low to average
  trusts (REITs)

Derivative Investment

Options and Warrants      Dependent on underlying security
Futures                   Dependent on underlying contracts

Figure 10.5

Cash            70%
U.S. Stock      18%
Foreign Stock    5%
Bond             7%
Other            0%

Note: Table made from pie chart.

Figure 10.6

Cash             7%
U.S. Stock      52%
Foreign Stock   10%
Bond            27%
Other            4%

Note: Table made from pie chart.

Figure 10.7

Cash            12%
U.S. Stock      55%
Foreign Stock   10%
Bond            20%
Other            3%

Note: Table made from pie chart.
No portion of this article can be reproduced without the express written permission from the copyright holder.
Copyright 2008 Gale, Cengage Learning. All rights reserved.

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Publication:The Case Approach to Financial Planning
Date:Jan 1, 2008
Previous Article:Chapter 9: property and liability insurance planning.
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