investment principles and risk · a wrap is a simple way of keeping an investor’s entire...

Investment Principles and risk

Learning Outcome 7

By the end of this learning material you will be able to demonstrate an ability to

apply the investment advice process.

© Aviva Financial Adviser Academy - 2 - v2017

7.1 The Investment Advice Process The objective of the investment advice process is to obtain the client’s agreement to a portfolio designed to meet their key requirements as closely as possible. ISO 22222: 2005 defines the financial planning process as having six stages

7.1 .1 Establish the client and adviser relationship An adviser should provide the client with a client agreement setting out:

• The service being provided, including timescales • The cost of any work the adviser will carry out and how it will be paid • How long the agreement lasts for • How often the adviser will meet with the client e.g. annually for reviews


7.1.2 Gathering Client Data and determine goals and expectations The adviser users a fact find to collate hard and soft facts in relation to a client’s: 7.1.3 Analysing the Situation

The adviser uses the information gleaned via the fact finding process to assess how realistic a client’s goals are in light of their circumstances. The adviser needs to consider what is achievable now and also what will be achievable in the future. A widely recognised order of financial priorities is:


7.1.4 Creating a risk profile

The adviser can use the outcomes of the attitude to risk questionnaire to establish the client’s:-

In addition to the client’s investment needs, the client’s overall risk profile gives the adviser a steer on what the appropriate asset allocation might be for that client. 7.1.5 Formulating the Investment Strategy for Asset Allocation

An investment strategy is applied using an asset allocation based on the client’s investment needs and their risk profile. Usually advisers have a number of portfolios matching different investment needs and risk profiles, each of which has assets allocated in various proportions based on expected risks. Normally the higher the exposure to equities and properties the higher the risk profile and the higher the level of return required by the client. 7.1.6 Selecting Investment Funds The selection of investments within an asset class can play a significant role in managing how much risk is taken within a portfolio. For example, blue chip shares are less risky than unlisted shares but they are within the same asset class. To avoid vast research being undertaken by an adviser, they may use a multi manager fund. It is then the responsibility of the multi manager fund manager to undertake the research and allocate client’s capital to selected fund managers. The role of the adviser then is to monitor the performance of the multi manager fund manager. If an adviser creates their own portfolio, they will need to have the resources to research, select and monitor it at regular intervals.


7.1.7 Ethical Issues

Clients may have ethical preferences that mean the adviser must take extra care when selecting funds for them. This process is known as ethical screening. There are three main ways in which to screen:

• Where the adviser excludes certain companies from a portfolio because of what they trade. For example, tobacco companies, arms manufacturers.

• Involves investing in companies with a responsible approach to business practices, products and services. For example, environmentally friendly companies

• Here the adviser is looking for companies who are neither positively harmful nor positively beneficial. These are known as socially responsible companies

7.1.8 Choice of Tax Wrappers Whilst the expected level of return after tax is an important consideration, tax savings should not drive investment choice. Investments should be selected on the basis of the client’s financial objectives and risk profile before applying any relevant tax wrappings that may be available. ISAs, Pensions, EISs and VCTs are examples of investments with different tax benefits that may be applied to an investor’s portfolio. 7.1.9 Wraps (Platforms)

A Wrap is a simple way of keeping an investor’s entire portfolio in a single account. The account is normally viewable online which enables an investor to view their entire holdings. The big advantage for the investor is ease of administration which can be useful to evaluate performance and in the completion of tax returns etc. for which the investor pays an explicit


charge.

7.1.10 Presenting Recommendations Most recommendations are presented to clients in the form of a report. The report should be written in a way that the client can understand and outline the client’s:

• Circumstances • Needs and a summary of recommendations • Risk profile • Asset allocation • Investment and wrapper selections

7.1.11 Implementing the recommendations The adviser should implement the plan, keeping details of the extent to which the client agreed to their recommendation and any areas where the client took a different approach. 7.1.12 Monitoring the Portfolio The adviser’s review service should be covered in the client’s report and in the client agreement. In addition to fund performance the adviser may want to check the existing portfolio against changes in:

• Client circumstances, views or objectives and needs • Availability of tax allowances • Legislation • Product availability • Market performance

It is important that any performance reviews are compared to a suitable benchmark.


7.2 Risk and return objectives There are four basic return objectives a client will be seeking:

Few clients, if any, will be willing to invest regardless of the risks involved. The achievement of a client’s financial objectives is usually constrained by:

• Their ability to tolerate risk • The time they have to invest • Their need for liquidity • Their capacity for risk • Tax • Legal/regulatory • Their unique needs/preferences

7.2.1 Investor Risk Tolerance Broadly speaking investors can be classified into one of five risk classes: Client risk classifications No Risk The risk averse client Low Risk The cautious client Medium Risk The balanced client Medium – High Risk The speculative client High Risk The adventurous client


The risk profile questionnaire and fact find will determine which of these classes an individual client slots into for any given financial objective.

7.2.2 Time Horizon Time is a major factor in determining an investment strategy. The shorter the time horizon, the greater the need to preserve capital and therefore the lower the risk that can sensibly be taken. In the long term, a well-diversified portfolio is likely to recover from any economic or natural disaster impact it may be put under than in the short term. The longer an investor can hold a portfolio, the longer they have to ride out any cyclical or other major downturns. 7.2.3 Cash Liquidity

All client portfolios need an element of cash liquidity. Cash liquidity avoids the need to encash investments in the event of an emergency and allows investors to take advantage of any short term investment opportunities. The amount of cash required by an investor should be assessed on an individual basis – care should be taken as cash can be an inefficient investment especially for high rate tax payers

The need for liquidity will generally reduce the risk that can be taken in a portfolio. 7.2.4 Resources

People with substantial income and assets have the financial capacity to accept a higher degree of risk as some capital loss may not necessarily put their lifestyle at risk. Those with modest capital are often more dependent on it and therefore have a lower financial capacity for risk. Clients may also wish to consider repaying debt before investing for the future. Where interest rates are higher on their debts than the potential they could receive on their investments, this may be a sensible idea and is a lower risk option. Where interest rates on debts are low, investing the capital sum may make a better return, but this is a higher risk option as the return must be higher than the rate of interest before a net gain is achieved. Investors need to consider the fact that borrowing criteria has moved considerably in recent times and they may no longer be able to borrow to the same amounts again should they wish to.


7.3 Applying Asset Allocation

Asset allocation allows an adviser to generate a portfolio that meets the specific needs and risk profile of their client. To apply asset allocation, the adviser needs a portfolio for each risk profile, for example: Cash

Fixed Interest Equities Property

Cautious Growth 15%

35% 40% 10%

Balanced Growth 10%

30% 50% 10%

Adventurous 5%

10% 75% 10%

7.3.1 Diversification Diversification is about minimising risk to the client by spreading their funds:- Negatively correlated investments also add diversification to a portfolio, as do hedge funds.


7.3.2 Strategic and tactical asset allocation

Strategic asset allocation is used by many advisers to set a long term position for a portfolio which is then managed by regular rebalancing reviews. Tactical asset allocation allows movement to take advantage of opportunities as and when they arise and will lead to a portfolio being under or over weighted in a particular asset compared to the strategic asset allocation model. 7.3.3 Rebalancing

If the asset allocation of a portfolio meets the client’s needs and risk tolerance, the adviser will recommend a rebalancing of the portfolio if the performance means that the portfolio has moved away from its agreed profile. Poor performing assets or high achieving assets may need to be bought and sold to rebalance a portfolio to bring it back within the range of asset holding that was agreed at the outset. Rebalancing does not usually give consideration to any CGT implications that may arise as its main objective is to keep the portfolio in line with the agreed risk profile

7.3.4 Accumulation and Decumulation

Whether a client is accumulating wealth or drawing on their capital (decumulating) is key to determining the correct portfolio. Clients who wish to accumulate assets over the longer term and who have regular amounts to invest, may take advantage of pound cost averaging within their portfolio by making regular purchases. Where clients are decumulating, care should be taken not to draw more income than can be sustained by their capital. If more is required, the client has a choice between adopting a higher risk profile or withdrawing a greater amount of income at the risk of eroding their capital. With decumulation portfolios, where good profits have been made, there is an argument that these should be encashed and used to cover immediate income needs. Whether the client is accumulating or decumulating, regular portfolio reviews are vital.


Investment Principles and Risk Learning Outcome 7 (LO7) – End of Module Test Multiple Choice Questions

Question Answer 1 - John, an independent financial adviser, is about to complete a fact find on a new client. Which of the following best describes the key areas in which information is required?

A. Assets and liabilities, needs and objectives, income and expenditure, tax status and priorities.

B. Priorities, needs and objectives, assets and liabilities, residency status and attitude to risk.

C. Needs and objectives, assets and liabilities, income and expenditure, priorities and attitude to risk.

D. Assets and liabilities, income and expenditure, priorities, ethical preferences and needs and objectives.

2 - Germaine's portfolio is benchmarked against the Hang Seng equity Index. This tells us that…

A. The Hang Seng equity Index most accurately reflects her attitude to risk.

B. Her portfolio is heavily weighted in Hong Kong stocks.

C. The performance of her portfolio will match the Hang Seng equity Index.

D. The majority of her portfolio is invested in Japanese companies.

3 - Which of the following clients is most likely to have a main financial objective of capital appreciation?

A. Cal, age 29, who has net disposable income of £900 a month.

B. Kiera, age 23, who has just got married and is expecting her first child.

C. Phil, age 64, who retired last year and is living off a private pension.

D. Amy, age 57, who intends to retire next year and live off her investment income

4 - A fund has an asset allocation of cash: 5%. Bonds: 10%. Property 10%. Equities 75%. Which of the following risk profiles does this match most closely?

A. Cautious Growth. B. Balanced Income. C. Income and Growth. D. Adventurous.


5 - What is the main purpose of rebalancing a portfolio?

A. To maximise use of the annual captial gains tax allowance.

B. To ensure the asset allocation of the portfolio continues to match the client's objectives and attitude to risk.

C. To ensure that the asset allocation of the portfolio continues to match the benchmark it is set against.

D. To minimise the risk faced by the portfolio.

- End of Questions -


Answers

Question Answer 1 - John, an independent financial adviser, is about to complete a fact find on a new client. Which of the following best describes the key areas in which information is required?

C. Needs and objectives, assets and liabilities, income and expenditure, priorities and attitude to risk.

2 - Germaine's portfolio is benchmarked against the Hang Seng equity Index. This tells us that…

B. Her portfolio is heavily weighted in Hong Kong stocks.

3 - Which of the following clients is most likely to have a main financial objective of capital appreciation?

A. Cal, age 29, who has net disposable income of £900 a month.

4 - A fund has an asset allocation of cash: 5%. Bonds: 10%. Property 10%. Equities 75%. Which of the following risk profiles does this match most closely?

D. Adventurous.

5 - What is the main purpose of rebalancing a portfolio?

B. To ensure the asset allocation of the portfolio continues to match the client's objectives and attitude to risk.

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