Investment Portfolio it Is Important

Investment Portfolio

It is important for financial planners to evaluate a customer's risk tolerance, which is the degree of comfort an investor has in taking risk (Investopedia, 2013). It is not good practice to assume it. The client interview process is the best way to test risk tolerance. There are several factors that go into risk tolerance. From a rational perspective, the client's wealth, current investment holdings and time horizon all play a role. A younger, wealthier client with a lot of sophisticated investments will have a higher risk tolerance than an older client who has little experience investing. The investment knowledge level of the client can also be gauged to some extent through an analysis of the client's existing portfolio. There are also, however, irrational components to risk aversion that need to be taken into consideration. During the interview process, some scenarios should be posed to get a sense of the client's reaction. The client should know that these are hypotheticals, lest he/she be given a fright. By posing scenarios that will mirror hypothetical investments and situations.

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The most common equity securities are common shares. These are partial ownership in a company. Share returns are based on a combination of dividends and capital gains. However, the risk with shares is that neither of these are guaranteed. As such, there are significant downside risks to share ownership -- the value of the shares could remain below what was paid, and they could go to zero.

There are several common debt securities, including Treasuries and corporate bonds. Treasuries represent borrowing from the U.S. government. They pay low rates of return, but are considered to be risk-free. There is some risk, however, in that they may pay a negative real return, once inflation is factored in. Corporate bonds -- or even other types of government bonds like municipal bonds -- also represent borrowing but they are riskier because these entities cannot print money like the Treasury can. Thus, other bonds pay higher rates of return than Treasuries, but usually not as much as equities. However, the nominal returns are guaranteed.

Mutual funds are a different category, in that they contain a large number of holdings within each fund. The fund is then managed for a fee (the MER). Mutual funds can fluctuate in price as equities do, even when they are comprised of bonds. While there is technically this significant downside risk, mutual funds are diversified to reduce downside risk.

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Bonds have default risk and interest rate risk. Default risk reflects the risk that the issuer is unable to pay either the interest or the principle. This form of risk is compensated for with the interest rate -- riskier bonds bear higher rates. Interest rate risk is the risk that the value of the bond's future cash flows is reduced through an increase in the prevailing interest rates. Expected changes in interest rates are built into the bond price, but any unexpected moves upward will reduce the real value -- not the nominal value -- of the bond.

Stocks have considerable more risk. Equity is subordinated to debt, which means that if the company goes bankrupt the bondholders get paid out first, before shareholders get anything. There is always the risk, therefore, that a shareholder could receive nothing for their shares, and lose all of their money. Even a bondholder might receive something -- pennies on the dollar -- in the event of bankruptcy, but a stockholder receives nothing at all This risk is only mitigated through diversification (Damodaran, n.d). There is also the risk for any given stock that it drops below the purchase price and never recovers, so that the investor will need to take a loss in order to sell. This is also the case with mutual funds. While less risky because of their diversified nature, they still function like equities and there is no guarantee either of distributions or of capital gains to mutual fund holders. This is true even for holders of bond funds, something that should be remembered -- bond funds do not have the same risk profile as bonds.

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An investor with high risk tolerance should have a portfolio that is oriented towards equities. This is because in general equities earn higher returns, and if the investor can tolerate the risk of losing money on the investment, then higher returns should be sought. For some investors, 100% equity might be fine, depending on their age, income level and what the rest of their wealth holdings look like. For most clients, however, equities should be part of a balanced portfolio that includes some bonds as well in order to preserve at least some of the capital. Equities can be 80%, bonds 20%. Mutual funds are only needed if the customer does not have enough money to buy a diversified equity portfolio. Clients with very high risk tolerance can also have derivatives, hedge funds or other more complex instruments, though these might need to be explained before putting them into the portfolio.