Research Paper on "Creating an Investment Portfolio"

Research Paper 3 pages (1010 words) Sources: 3

[EXCERPT] . . . .

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.

3.

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 --… READ MORE

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