Wealth Management

Topic:- Investment Planning

Index
INTRODUCTION
Types of investment risk
Asset allocation strategies
Active & Passive investment Staegies

INTRODUCTION
Investment risk can be defined as the probability or likelihood of occurrence of losses
relative to the expected return on any particular investment. Description: Stating simply, it
is a measure of the level of uncertainty of achieving the returns as per the expectations of
the investor.

Interest Rate Risk

Interest rate risk is the possibility that a fixed-rate debt instrument will decline in value as a
result of a rise in interest rates. Whenever investors buy securities that offer a fixed rate of
return, they are exposing themselves to interest rate risk. This is true for bonds and also for
preferred stocks.

Business Risk
Business risk is the measure of risk associated with a particular security. It is also known
as unsystematic risk and refers to the risk associated with a specific issuer of a security.
Generally speaking, all businesses in the same industry have similar types of business risk.
But used more specifically, business risk refers to the possibility that the issuer of a stock or a
bond may go bankrupt or be unable to pay the interest or principal in the case of bonds. A
common way to avoid unsystematic risk is to diversify - that is, to buy mutual funds, which
hold the securities of many different companies.

Credit Risk
This refers to the possibility that a particular bond issuer will not be able to make expected
interest rate payments and/or principal repayment. Typically, the higher the credit risk, the
higher the interest rate on the bond.

Taxability Risk
This applies to municipal bond offerings, and refers to the risk that a security that was issued
with tax-exempt status could potentially lose that status prior to maturity. Since municipal
bonds carry a lower interest rate than fully taxable bonds, the bond holders would end up
with a lower after-tax yield than originally planned.

Call Risk
Call risk is specific to bond issues and refers to the possibility that a debt security will be
called prior to maturity. Call risk usually goes hand in hand with reinvestment risk, discussed
below, because the bondholder must find an investment that provides the same level of
income for equal risk. Call risk is most prevalent when interest rates are falling, as companies
trying to save money will usually redeem bond issues with higher coupons and replace them
on the bond market with issues with lower interest rates. In a declining interest rate
environment, the investor is usually forced to take on more risk in order to replace the same
income stream.

Inflationary Risk
Also known as purchasing power risk, inflationary risk is the chance that the value of an asset
or income will be eroded as inflation shrinks the value of a country's currency. Put another
way, it is the risk that future inflation will cause the purchasing power of cash flow from an
investment to decline. The best way to fight this type of risk is through appreciable

investments, such as stocks or convertible bonds, which have a growth component that stays
ahead of inflation over the long term.

Liquidity Risk
Liquidity risk refers to the possibility that an investor may not be able to buy or sell an
investment as and when desired or in sufficient quantities because opportunities are limited. A
good example of liquidity risk is selling real estate. In most cases, it will be difficult to sell a
property at any given moment should the need arise, unlike government securities or blue
chip stocks.

Market Risk
Market risk, also called systematic risk, is a risk that will affect all securities in the same
manner. In other words, it is caused by some factor that cannot be controlled by
diversification. This is an important point to consider when you are recommending mutual
funds, which are appealing to investors in large part because they are a quick way to
diversify. You must always ask yourself what kind of diversification your client needs.

Reinvestment Risk
In a declining interest rate environment, bondholders who have bonds coming due or being
called face the difficult task of investing the proceeds in bond issues with equal or greater
interest rates than the redeemed bonds. As a result, they are often forced to purchase
securities that do not provide the same level of income, unless they take on more credit or
market risk and buy bonds with lower credit ratings. This situation is known as reinvestment
risk: it is the risk that falling interest rates will lead to a decline in cash flow from an
investment when its principal and interest payments are reinvested at lower rates.

Social/Political / legislative Risk

Risk associated with the possibility of nationalization, unfavorable government action or
social changes resulting in a loss of value is called social or political risk. Because the U.S.
Congress has the power to change laws affecting securities, any ruling that results in adverse
consequences is also known as legislative risk.

Currency/Exchange Rate Risk

Currency or exchange rate risk is a form of risk that arises from the change in price of one
currency against another. The constant fluctuations in the foreign currency in which an
investment is denominated vis--vis one's home currency may add risk to the value of a
security.
American investors will need to convert any profits from foreign assets into U.S. dollars. If
the dollar is strong, the value of a foreign stock or bond purchased on a foreign exchange will
decline. This risk is particularly augmented if the currency of one particular country drops
significantly and all of one's investments are in that country's foreign assets. If the dollar is
weak, however, the value of the American investor's foreign assets will rise.
Understandably, currency risk is greater for shorter term investments, which do not have time
to level off like longer term foreign investments.

WHAT IT IS:
Reinvestment risk is the chance that an investor will not be able to reinvest cash flows from
aninvestment at a rate equal to the investment's current rate of return.

HOW IT WORKS (EXAMPLE):

For example, consider a Company XYZ bond with a 10%yield to maturity (YTM). In order
for an investor to actually receive the expected yield to maturity, she must reinvest
the coupon payments she receives at a 10% rate. This is not always possible. If the investor
could only reinvest at 4% (say, because market returns fell after the bonds were issued), the
investor's actual return on the bondinvestment would be lower than expected.
Although the primary component of reinvestment risk is the ability to effectively reinvest
coupon payments, the probability of losing those coupon payments in the first place also
affects reinvestment risk. For example, callable securities (like callable bonds and
redeemable preferred stock) carry extra reinvestment risk because if they are called away, the
investor will not even collect all the expected interest payments, much less reinvest them
effectively.
Remember that issuers usually call bonds when interest rates fall, leaving the investor to
reinvest the proceeds at a lower rate. So if Company XYZ's bonds are callable, and rates fall
from 10% to 3%, Company XYZ will probably call the 10% bonds and issue new bonds with
a lower coupon. The holders of the 10% bonds would receive their principal back (and
probably a small call premium), but they would then have to find other investments, none of
which would probably pay as well as the Company XYZ bonds.
WHY IT MATTERS:
Reinvestment risk is most common in bond investing, but any investment that
generates cash flows exposes the investor to this risk.
There are some ways to mitigate reinvestment risk. One way is to invest
in noncallable securities. This keeps the issuer from calling away highcoupon investments when market rates fall. (Note, however, that the investor must still find
effective ways to reinvest those coupon payments in what has become a low-rate
environment).
Zero-coupon bonds also help investors reduce their reinvestment risk because zero-coupon
bonds don't pay coupons. However, the investor must still decide how to reinvest the
proceeds when the bond matures.

Asset Allocation Strategies

What is a 'Strategic Asset Allocation'
A portfolio strategy that involves setting target allocations for various asset classes, and
periodically rebalancing the portfolio back to the original allocations when they deviate
significantly from the initial settings due to differing returns from various assets. In strategic
asset allocation, the target allocations depend on a number of factors such as the investors
risk tolerance,time horizon and investment objectives and may change over time as these
parameters change. Strategic asset allocation is compatible with a buy and hold strategy, as
opposed to tactical asset allocation which is more suited to an active trading approach.
Strategic and tactical asset allocation are based on modern portfolio theory, which
emphasizes diversification in order to reduce risk and improve portfolio returns.
Strategic Asset Allocation
This method establishes and adheres to a "base policy mix" - a proportional combination of
assets based on expected rates of return for each asset class. For example, if stocks have
historically returned 10% per year and bonds have returned 5% per year, a mix of 50% stocks
and 50% bonds would be expected to return 7.5% per year.
Constant-Weighting Asset Allocation
Strategic asset allocation generally implies a buy-and-hold strategy, even as the shift in values
of assets causes a drift from the initially established policy mix. For this reason, you may
choose to adopt a constant-weighting approach to asset allocation. With this approach, you
continually rebalance your portfolio. For example, if one asset is declining in value, you
would purchase more of that asset; and if that asset value is increasing, you would sell it.
There are no hard-and-fast rules for timing portfolio rebalancing under strategic or constantweighting asset allocation. However, a common rule of thumb is that the portfolio should be
rebalanced to its original mix when any given asset class moves more than 5% from its
original value.
Tactical Asset Allocation
Over the long run, a strategic asset allocation strategy may seem relatively rigid. Therefore,
you may find it necessary to occasionally engage in short-term, tactical deviations from the
mix to capitalize on unusual or exceptional investment opportunities. This flexibility adds
a market timing component to the portfolio, allowing you to participate in economic
conditions more favorable for one asset class than for others.
Tactical asset allocation can be described as a moderately active strategy, since the overall
strategic asset mix is returned to when desired short-term profits are achieved. This strategy
demands some discipline, as you must first be able to recognize when short-term
opportunities have run their course, and then rebalance the portfolio to the long-term asset
position.

Dynamic Asset Allocation

Another active asset allocation strategy is dynamic asset allocation, with which you
constantly adjust the mix of assets as markets rise and fall, and as the economy strengthens
and weakens. With this strategy you sell assets that are declining and purchase assets that are
increasing, making dynamic asset allocation the polar opposite of a constant-weighting
strategy. For example, if the stock market is showing weakness, you sell stocks in
anticipation of further decreases; and if the market is strong, you purchase stocks in
anticipation of continued market gains.
Insured Asset Allocation
With an insured asset allocation strategy, you establish a base portfolio value under which the
portfolio should not be allowed to drop. As long as the portfolio achieves a return above its
base, you exercise active management to try to increase the portfolio value as much as
possible. If, however, the portfolio should ever drop to the base value, you invest in risk-free
assets so that the base value becomes fixed. At such time, you would consult with your
advisor on re-allocating assets, perhaps even changing your investment strategy entirely.
Insured asset allocation may be suitable for risk-averse investors who desire a certain level of
active portfolio management but appreciate the security of establishing a guaranteed floor
below which the portfolio is not allowed to decline. For example, an investor who wishes to
establish a minimum standard of living during retirement might find an insured asset
allocation strategy ideally suited to his or her management goals.
Integrated Asset Allocation
With integrated asset allocation, you consider both your economic expectations and your risk
in establishing an asset mix. While all of the above-mentioned strategies take into account
expectations for future market returns, not all of the strategies account for investment risk
tolerance. Integrated asset allocation, on the other hand, includes aspects of all strategies,
accounting not only for expectations but also actual changes in capital markets and your risk
tolerance. Integrated asset allocation is a broader asset allocation strategy, albeit allowing
only either dynamic or constant-weighting allocation. Obviously, an investor would not wish
to implement two strategies that compete with one another.

CASE STUDY

BREAKING DOWN 'Strategic Asset Allocation'

For example, 60-year old Mrs. Smith, who has a conservative approach to investing and is
five years away from retirement, may have a strategic asset allocation of 40% equities / 40%
fixed income / 20% cash. Assume Mrs. Smith has a $500,000 portfolio, and rebalances her
portfolio annually. The dollar amounts allocated to the various asset classes at the time of
setting the target allocations would therefore be Equities $200,000, Fixed Income $200,000
and Cash $100,000.

After a years time, suppose the equity component of the portfolio has generated total
returns of 10%, while fixed income has returned 5% and cash 2%. The portfolio composition
now is Equities $220,000, Fixed Income $210,000 and Cash $102,000.
The portfolio value is now $532,000, which means the overall return on the portfolio over the
past year was 6.4%. The portfolio composition now is Equities 41.3%, Fixed Income 39.5%
and Cash 19.2%.
Based on the original allocation, the portfolio value of $532,000 should be allocated as
follows
Equities $212,800, Bonds $212,800 and Cash $106,400. The table below shows the
adjustments that have to be made to each asset class to get back to the original or target
allocation.

Thus, $7,200 from the equity component has to be sold in order to bring the equity allocation
back to 40%, with the proceeds used to buy $2,800 of bonds and the balance $4,400 allocated
to cash.
Note that while changes to target allocations can be carried out at any time, they are done
relatively infrequently. In this case, Mrs. Smith may change her allocation in five years
when she is on the verge of retirement to 20% equities, 60% fixed income and 20% cash, so
as to reduce portfolio risk. Depending on the portfolio value at that time, this would
necessitate significant changes in the composition of the portfolio to achieve the new target
allocations.

ACTIVE AND PASSIVE INVESTMENT STRATEGIES

What is 'Passive Investing'

Passive investing is an investment strategy that aims to maximize returns over the long run by
keeping the amount of buying and selling to a minimum. The idea is to avoid the fees and the
drag on performance that potentially occur from frequent trading. Passive investing is not
aimed at making quick gains or at getting rich with one great bet, but rather on building slow,
steady wealth over time.

BREAKING DOWN 'Passive Investing'

Also known as a buy-and-hold strategy, passive investing involves buying a security with the
intention of owning it for many years. Unlike active traders, passive investors are not
attempting to profit from short-term price fluctuations, or otherwise "time the market." The
basic assumption that underpins a passive investment strategy is that the market generally
posts positive returns given enough time.
Passive Investing Strategy
Traditionally, passive investors attempt to replicate market performance by constructing welldiversified portfolios of individual stocks, a process that can require extensive research.
With the introduction of index funds in the 1970s, achieving returns in line with the market
became much easier. In the 1990s, exchange-traded funds, or ETFs, that track major indices,
such as the SPDR S&P 500 ETF (SPY), simplified the process even further by allowing
investors to trade index funds as though they were stocks.
Now that mutual funds and ETFs allow for index investing with relatively little initial
research, the most difficult skill for passive investors to master is emotional control. Resisting
the urge to sell when the market experiences a downturn requires patience and a strong
stomach. When a rapid sell-off triggered circuit breakers that shut down trading in August of
2015, for example, iShares Core S&P 500 ETF (IVV) and many other ETFs tracking the S&P
500 suffered significant losses, as investors panicked at the lack of pricing information and
liquidated their holdings.
Passive investors must have the presence of mind to weather these storms and trust that the
market will correct itself with time.

Testing Passive Investing

A highly vocal defendant of passive investing is value investor Warren Buffett. His approach
as Chairman and CEO of Berkshire Hathaway Inc. (BRK-A, BRK-B) exemplifies some of
the principles of passive management, including ultra-long investment horizons and
infrequent selling. In a sense, however, he is an active investor, since he invests in companies
based on particularcompetitive advantages.

While his style of investing cannot be considered fully passive, Buffett is a big proponent of
index investing. In 2008, to prove the superiority of passive management, Buffett challenged
the hedge fund industry the quintessential active investors to a 10-year contest. He put a
million dollars in Vanguard's S&P 500 Admiral Fund (the first index fund available to retail
investors), while Protege Partners LLC, the hedge fund that took him up on his challenge,
picked five fund of funds.
Though the bet is still running as of 2016, Buffett's passive strategy has proven its worth thus
far. By the end of 2015, Buffett's passive bet had generated a 66% cumulative
return compared to Protege's 22%.
Passive Strengths
Even for wealthy investors, passive holdings have a strong appeal, says Christopher C.
Geczy, Wharton adjunct professor of finance and academic director of the Wharton Wealth
Management Initiative. The big issue still applies, he says. Thats the issue of whether you
believe in trying to beat the market or whether you believe in [minimizing] costs. Some of the
most successful entrepreneurs I know think about costs.
Passive, or index-style investments, buy and hold the stocks or bonds in a market index such
as the Standard & Poors 500 or the Dow Jones Industrial Average. A vast array of indexed
mutual funds and exchange-traded funds track the broad market as well as narrower sectors
such as small-company stocks, foreign stocks and bonds, and stocks in specific industries.
Among the benefits of passive investing, say Geczy and others:

Very low fees -- since there is no need to analyze securities in the index

Good transparency -- because investors know at all times what stocks or bonds an
indexed investment contains

Tax efficiency -- because the index funds buy-and-hold style does not trigger large
annual capital gains tax.

What is 'Active Investing'

Active investing is an investment strategy involving ongoing buying and selling actions by
the investor. Active investors purchase investments and continuously monitor their activity in
order to exploit profitable conditions.

BREAKING DOWN 'Active Investing'

Active investing is highly involved. Unlike passive investors, who invest in a stock when
they believe in its potential for long-term appreciation, active investors will typically look at
the price movements of their stocks many times a day. Typically, active investors are seeking
short-term profits.
Active Advantages
Still, many financial advisers recommend actively managed investments for significant
portions of their clients portfolios. Active management includes mutual funds and exchangetraded funds, as well as portfolios of stocks, bonds and other holdings managed by financial
advisers. Among the benefits they see:

Flexibility because active managers, unlike passive ones, are not required to hold
specific stocks or bonds

Hedging the ability to use short sales, put options, and other strategies to insure
against losses

Risk management the ability to get out of specific holdings or market sectors when
risks get too large

Tax management including strategies tailored to the individual investor, like selling
money-losing investments to offset taxes on winners.