Foundation of Personal
Financial Planning
Unit 3: Investment planning,
tools and risk I
Readings
• Chapter 5 and 11, Keown, A., 2023. Personal Finance: Turning Money into
Wealth. 9th ed. Pearson.
• Chapter 5, Madura, J., 2020. Personal Finance. 7th ed. Pearson.
The Investment
Planning Process
Investment planning
• Planning phase is crucial and involves considering assets, income, liquidity
needs, and retirement goals.
• Implementation phase includes buying, selling, and rebalancing securities.
Requires appropriate licensing if securities transactions are involved.
• Monitoring and updating are ongoing processes to track progress and
adjust the investment plan as needed.
• Standalone vs. integrated: Investment planning phases can be
independent or part of a broader financial plan.
Planning phase
• It involves a deep dive into the client's financial situation to create a
tailored investment strategy.
• Investment Policy Statement (IPS)
• An IPS is a formal document that outlines the client's investment goals,
risk tolerance, and asset allocation which serves as a roadmap for
investment decisions.
Planning phase
Components of an IPS
• Client information: Financial goals, risk tolerance, time horizon, and
liquidity needs.
• Investment objectives: Specific financial targets and desired returns.
• Asset allocation: The desired mix of asset classes (stocks, bonds, cash, etc.).
• Investment strategies: The approach to achieving investment objectives.
• Performance evaluation: How investment performance will be measured.
• Rebalancing policy: Guidelines for adjusting the portfolio to maintain
desired asset allocation.
Planning phase
• Understanding the Client's Investment Profile
• Investor experience
• Investment history
• Investment preferences
• Market behavior
• Understanding the Client’s financial conditions
• Statement of financial position
• Personal spending plan
Planning phase
Defining Specific Financial Goals
• SMART goals
• Goals should be Specific, Measurable, Achievable, Relevant, and Time-
bound.
• Goal clarity
• Clearly defining financial objectives (e.g., retirement savings, education
funding).
• Dollar amounts and time horizons
• Quantifying goals with specific financial targets and deadlines.
Planning phase
Understanding Client's Risk Profile
• Qualitative assessment:
• Understanding the client's psychological reaction to market fluctuations
and their comfort level with risk.
• Quantitative assessment:
• Using the following tools to measure risk tolerance numerically.
• Client interviews
• Risk tolerance questionnaires
• Psychometric tests
Planning phase
Understanding Client Constraints
• Liquidity Constraints
• Emergency funds: Maintaining sufficient cash reserves for unexpected expenses.
• Impact on investment strategy: Balancing liquidity needs with investment goals.
• Time Horizon Constraints
• Short-term: Emphasizes capital preservation and liquidity.
• Intermediate-term: Balances growth and preservation.
• Long-term: Focuses on growth and potential for higher returns.
• Human Capital Risk
• Employment stability: Assessing the client's job security and income potential.
• Insurance coverage: Evaluating the adequacy of disability and life insurance.
• Dependency on income: Understanding the client's reliance on employment income.
IPS Example
Monitoring and Updating Phase
• The Ongoing Nature of Investment Planning
• Monitoring and updating are essential components of the investment
planning process.
• Deep discovery: The initial planning phase lays the groundwork, but
ongoing monitoring is crucial to ensure the plan remains aligned with the
client's goals.
• Performance evaluation: Assessing portfolio performance beyond simple
return figures is necessary to understand true investment success.
Challenges in Performance Evaluation
• Risk-adjusted returns: Considering risk when comparing investment
performance is vital.
• Performance measurement tools: Various metrics (Sharpe ratio, Treynor
measure, Jensen's alpha, information ratio) can provide different insights.
Case Study
Before Investing
1.
Decide what your client’s goals are.
2.
Know how much can your client set aside to meet those goals.
3.
Know your client’s risk profile
4.
Know the difference between investing and speculating.
Setting Investment Goals
•
When assisting your client’s investment plan,
• Write down your client’s goals and prioritize them.
• Attach costs to them.
• Figure out when the money for those goals will be needed.
• Periodically reevaluate the goals.
Setting Investment Goals
•
Formalize goals with investment timeframe:
• Short-term—within 1 year
• Intermediate-term—1–10 years
• Long-term—over 10 years
•
Goals should be realistic:
• What are the consequences if the goal is not accomplished?
• Are your client willing to make financial sacrifices to reach this goal?
• How much money is needed?
• When does your client need the money?
Case: Planning for Your Child's Canadian Education
• Factors to Consider When Estimating Education Fund
• Cost of Education
• Time Horizon
• Financial Aid and Scholarships
• Investment Returns
• Inflation rate
• Higher than General Inflation: Education costs have typically increased
at a rate of about 3-4% annually in Canada, while general inflation has
been lower.
Case: Planning for Your Child's Canadian Education
• 2024-2025 Tuition Fees — New Students
Case: Planning for Your Child's Canadian Education
• 2024-2025 Tuition Fees — New Students
• The total fee per year is around CAD84000
Case: Planning for Your Child's Canadian Education
Assumptions
Child age
Expected age to the college
Edcuation cost inflation
Investment return after the first year of college
Invetment return during accumulation
5
18
4%
1%
6%
Budgeting: Cost of Education
𝐶𝑎𝑠ℎ𝑓𝑙𝑜𝑤 2037
𝐶𝑎𝑠ℎ𝑓𝑙𝑜𝑤 2038
𝐶𝑎𝑠ℎ𝑓𝑙𝑜𝑤 2039
𝐶𝑎𝑠ℎ𝑓𝑙𝑜𝑤 2040
2024
84,000.00
2037
139,866.17
139,866.17
PV@1%(2037)
584,888.61
2038
145,460.82
144,020.62
2039
151,279.25
148,298.46
= 84000 × 1.04 13 = 139866.17
= 84000 × 1.04 14 = 145460.82
= 84000 × 1.04 15 = 148298.46
= 84000 × 1.04 16 = 152703.36
𝑃𝑉@1% 2037 = 139866.17 +
145460.82 151279.25 157330.42
+
+
= 584888.61
1.01
1.012
1.013
2040
157,330.42
152,703.36
Case: Planning for Your Child's Canadian Education
Case: Planning for Your Child's Canadian Education
Lump Sum Investment
• 𝑃𝑉2024 @6%
=
584,888.61
= 274,218.60
(1.06)13
• 𝐶𝐴𝐷274,218.60 = 𝐻𝐾𝐷1,574,014.78
Annual Investment
• Use Financial Calculator
• 𝐹𝑉 = 584,888.61; 𝑁𝑝𝑒𝑟 = 13; 𝑅𝑎𝑡𝑒 = 6%, 𝑃𝑉 = 0
• 𝑃𝑀𝑇 = 𝐶𝐴𝐷30,975.76 = 𝐻𝐾𝐷177,800.87
Case: Planning for Your Child's Canadian Education
Year
Age
2024
2025
2026
2027
2028
2029
2030
2031
2032
2033
2034
2035
2036
2037
2038
2039
2040
Education Cost
5
84000.00
6
87360.00
7
90854.40
8
94488.58
9
98268.12
10
102198.84
11
106286.80
12
110538.27
13
114959.80
14
119558.19
15
124340.52
16
129314.14
17
134486.71
18
139866.17 $
19
145460.82
20
151279.25
21
157330.42
Lump Sum
Annual Saving Balance in the A/C
$
274,218.60 $ 30,975.76
$
290,671.72 $ 30,975.76 $
30,975.76
$
308,112.02 $ 30,975.76 $
63,810.07
$
326,598.74 $ 30,975.76 $
98,614.44
$
346,194.67 $ 30,975.76 $
135,507.06
$
366,966.35 $ 30,975.76 $
174,613.25
$
388,984.33 $ 30,975.76 $
216,065.81
$
412,323.39 $ 30,975.76 $
260,005.52
$
437,062.79 $ 30,975.76 $
306,581.61
$
463,286.56 $ 30,975.76 $
355,952.27
$
491,083.75 $ 30,975.76 $
408,285.17
$
520,548.78 $ 30,975.76 $
463,758.04
$
551,781.70 $ 30,975.76 $
522,559.29
584,888.61 $
584,888.61
$
584,888.61
End of the Case
Study
Financial Reality Check
•
Have a grip on your client’s financial affairs.
• Make sure your client is living within your means.
• Have adequate insurance.
• Keep emergency funds.
Investment Choices
CASH AND CASH EQUIVALENTS
• GUARANTEED INVESTMENT CONTRACT
• BOND
• STOCK
• MUTUAL FUND
• EXCHANGE TRADED FUND
• REAL ESTATE
• ALTERNATIVE INVESTMENTS
•
The Returns from Investing
•
Capital gain or loss
• Gain (or loss) on the sale of a capital asset.
•
Income return
• Payments you receive directly from the company or organization in
which you’ve invested.
Table 2.1
Total Returns of Two Investments
Table 2.2
Historical Investment Data for ExxonMobil Corp.(X O M)
Table 2.3
Historical Returns for Major Asset Classes (1900-2017)
Measuring Return
• Holding Period Return
• Holding period: the period of time over which one wishes to measure the
return on an investment.
• Understanding Return Components
• Realized Return: income received by the investor during the investment
period
• Paper Return: the capital gain or loss that has been achieved but not yet
realized (no sale has taken place)
Measuring Return
• Holding Period Return
• Computing the Holding Period Return
• Holding Period Return (HPR): the total return earned from holding
an investment for a specified time (the holding period); usually
one year or less.
Holding period return =
Income during period + Capital gain (or loss) during period
Beginning investment value
Table 4.6
Key Financial Variables for Four Investments
Measuring Return
• The Internal Rate of Return
•
IRR for a Stream of Income
• Investments such as income-oriented stocks and bonds typically provide
the investor with an income stream.
• The IR R on an investment that pays income periodically is the discount
rate that equates the present value of the investment’s cash flows to its
current price.
Measuring Return
•
The Internal Rate of Return
•
Internal Rate of Return: The discount rate that equates an
investment’s cost to the present value of the benefits that it
provides for the investor.
•
IRR for a Single Cash Flow
• E.g., investments such as U.S. savings bonds, stocks paying
no dividends, and zero-coupon bonds, that provide no
periodic income.
• Example: What is the yield (IRR) on an investment costing
$1,000 today that you expect will be worth $1,400 at the end
of a 5-year holding period?
Measuring Return
IRR for a Single Cash Flow
Entry in Cell B6 is = Rate (B5,0,B3,B4,0). The minus sign appears before the
$1,000 in B3 because the cost of the investment is treated as a cash outflow.
Measuring Return
IRR for a Stream of Income
Entry in Cell B11 is = IRR (B3 : B10). The minus sign appears before the
$1,100 in B3 because the cost of the investment is treated as a cash
outflow.
Expected Return
• Expected (Mean) Return
• Calculated as a weighted average of the possible returns, where the
weights correspond to the probabilities.
Variance and Standard Deviation (1 of 2)
• Variance
• The expected squared deviation from the mean
• Standard Deviation
• The square root of the variance
• Both are measures of the risk of a probability distribution
Variance and Standard Deviation (2 of 2)
• In finance, the standard deviation(SD) of a return is also referred to
as its volatility
• The standard deviation is easier to interpret because it is in the
same units as the returns themselves
Risk: The Other Side of the Coin
• Risk: the uncertainty surrounding the actual return that an investment will
generate.
• Risk-Return Tradeoff: the relationship between risk and return in which
investors want to obtain the highest possible return for the level of risk that they
are willing to take.
• Sources of Risk
• The Risk of a Single Asset
• Assessing Risk
• Steps in the Decision Process: Combining Return and Risk
Table 4.10
Historical Returns and Standard Deviations for Select Asset Classes
(1900-2017)
Figure 4.1
The Risk-Return Tradeoff Around the World
Figure 4.2
Risk Preferences
Sources of Risk in the Risk-Return Trade-Off
Interest rate risk
• Fluctuations in interest rates directly impact bond prices. When interest
rates rise, assets prices generally fall, and vice versa.
• Inflation risk
• This risk arises from the erosion of purchasing power due to rising
prices.
• Business risk
• This risk pertains to factors specific to a company or industry, such as
poor management decisions, increased competition, or regulatory
changes.
•
Sources of Risk in the Risk-Return Trade-Off
Liquidity risk
• This risk arises from the possibility of difficulty selling an investment quickly at a fair
price.
• Market risk
• This type of risk stems from overall market factors that affect all securities, such as
economic downturns, geopolitical events, or changes in investor sentiment.
• Political risk
• This risk relates to political instability, government policies, or regulatory changes
that can negatively impact investment returns, particularly in emerging markets.
• Exchange rate risk
• Fluctuations in exchange rates can affect returns for investments denominated in
foreign currencies.
•
Diversification
•
The elimination of risk by investing in different assets.
•
Allows extreme good and bad returns to cancel each other out.
•
Reduced risk without affecting expected return.
Diversifying away Risk
•
Systematic or market-related or nondiversifiable risk
• the portion of a security’s risk or variability that cannot be eliminated
through diversification.
•
Unsystematic or firm-specific or company-unique risk or diversifiable risk
• the risk or variability that can be eliminated with diversification.
Figure 11.2
The Reduction of Risk as the Number of Stocks in the Portfolio Increases
The Time Dimension of Investing and Asset Allocation
• As the length of the investment horizon increases, you can afford to invest
in riskier assets.
• If investment horizon is longer, will probably end up with a lot more if you
invest in some risky assets.
Meeting Your Investment Goals and the Time Dimension
of Risk
• With any long-term investment, there will be bad years and good years.
• With time, dispersion (variability) of returns in these years converges
toward the average.
• Investment in bonds will give less uncertainty over time but will give
smaller ultimate value than investing in riskier assets like stocks.
Reduction of Risk over Time, 1971–2020
Each bar shows the range of compound annual returns for each asset class over the period 1971–2020.
Asset Allocation
• Asset allocation – how your money should be divided among stocks,
bonds, and other investments.
• Investments diversified in different classes of investments
• Common stocks more appropriate for the long-term horizon
• Asset allocation is the most important investing task that is not a one-time
decision.
Asset Allocation
• Key factors to consider when determining asset allocation include:
• Diversification: Spreading investments across various asset classes to
reduce risk.
• Time horizon: The longer the investment horizon, the greater the
potential for risk-taking.
• Risk tolerance: Individual comfort level with market fluctuations.
• Financial situation: Current financial status, including income, debt, and
emergency fund.
• Help your client to create a portfolio that aligns with their financial goals
and risk tolerance.
Figure 11.4
Different Asset Allocation Portfolios with Average Returns, 1971-2020