Question

Scenario: You are a financial advisor. You have a client named Steve that hopes to retire in 10 years. Steve has $400,000 to invest. You have another client named Liz. Liz is young and is hoping to retire in 30 years. She currently has $50,000 to invest. 1. How would you advise Steve to invest. Note specifically how you would diversify to minimize risk while maximizing his return on investment. You must account for all money and identify which financial assets you think are best for Steve. 2. How would you advise Liz to invest. Note specifically how you would diversify to minimize risk while maximizing your return on investment. You must account for all money and identify which financial assets you think are best for Liz. 3. Briefly explain why you had a different strategy for Steve than you had for Liz

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Answer 1

1. Steve hopes to retire in 10 years. So, the rationale here is that Steve would redeem his investments, either lump-sump or in small amounts every month to sustain for a living and other expenses. Here, Steve must divide his portfolio into different parts. A majority of Steve's investments should be in Fixed income assets- of which about half should be in risk-free government bonds and another half in AAA-rated corporate bonds. Hence, a major part of Steve's portfolio would consist of either debt-mutual funds or highly rated liquid bonds. (Let's say this proportion if 65%). The majority of the rest of the money should be invested either in large-cap mutual funds or less-risky large capitalization company stocks. This would ensure that the volatility in the return is not too high. (Let's say this proportion is 25%). The remaining small proportion of investment should be invested in small-cap high growth companies(Let's say this proportion is 10%). This would ensure that majority of the portfolio is less risky, and to compensate for lesser return, we invest a small proportion of capital in high risk, high return small-cap stocks.

2. Liz is young and his retirement is about 30 years ahead gives him ample risk-taking opportunities on his investment which would be compensated by higher returns since his retirement is still 30 years from now. Hence, Steve should invest about 30% of his portfolio in either a small-cap mutual fund or high-growth stocks. About 1/4th ie. 25% of the portfolio should be kept in less risky treasury bonds. The remaining proportion, about 55% should be invested in large-capitalization company stocks or large-cap mutual funds. The benefit of this strategy is that since Liz has 30 years for his retirement, the investment horizon being higher, he can take higher risk, and will be compensated with a higher return. Also, he will not be bothered about the liquidity, since he is young and working.

3. We had a different strategy for Liz and Steve. This is because, on retirement, Steve would require liquid investment for the fulfillment of his expenses and hence, would not want to invest in illiquid, high risk, high growth asset class. Hence, the major proportion of his investment is kept in highly liquid treasury and AAA rated corporate bonds. On the other hand, Liz is young and can take on higher risk, as asset return are less volatile in the larger investment horizon and hence, Liz can afford to invest in high growth stock, which might not be liquid and could be volatile in the short run, but would fetch him higher than market returns in the longer run.