Chapter 4 - Getting to Know the Client

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  1. What types of return (i.e. safety of capital, current income, growth) is the client likelyseeking in the following situations?
    a) a 30-year-old investor saving for retirement;
    b) a 25-year-old investor saving for a car down payment;
    c) a couple saving for their 10-year-old’s university education.
    • (a) A 30-year-old investor has a very long investment horizon until retirement — perhapsas long as 35 years. This long horizon would permit the investor to invest in fundsoffering capital gains (or growth). This assumes that the investor’s risk tolerance,investment knowledge, financial and personal circumstances also allow for volatile,growth-oriented investments.
    • (b) A car down payment likely has a fairly short-term horizon. Even if the investor is quiterisk-tolerant, volatile investments would not be suitable. The investor is likely to beseeking safety of capital.
    • (c) A 10-year-old has about eight years (until age 18) before university. This is amedium-term horizon, which would be consistent with current income as the type ofreturn.
  2. What is an investor’s asset allocation? Give a possible asset allocation for a highly risk-averse client with a large, young family and a 30-year investment horizon for his stated goal of investing for retirement.
    An asset allocation is the weighting of the different types of securities (including mutual funds) within an investor’s investment portfolio. Although we would also like to have information about this client’s income and net worth, it is fairly clear that only a low-risk asset allocation would be appropriate given his/her investment constraints. This is true in spite of the long retirement investment horizon. A possible allocation might be 15% equity funds, 30% bond funds, and 55% money market funds. If the client is extremely risk adverse, only Money Market or guaranteed investments will be suitable.
  3. Why is a household budget an important thing for clients to develop?
    A household budget is the game plan for investment saving. It allows clients to move towards their investment goals in a logical and orderly manner.
  4. Define net worth. What can a client’s net worth tell you about that client?
    Net worth is the difference between an investor’s assets and liabilities. It can also be expressed as the difference between what the client owns and what they owe. An investor’s net worth is particularly informative if we know what it consists of. For example, if a portion of that net worth is made up of investments of different types, this indicates a certain level of investment sophistication. If the portfolio is made up of a substantial amount of risky securities (such as growth stocks), then we would be justified in inferring that the client has a fairly high level of risk tolerance.
  5. Explain why a client’s asset allocation is likely to change over time.
    A client’s asset allocation is likely to change over time because financial objectives and constraints will likely change over time. For example, as clients age, their investment horizon for retirement becomes shorter. Shorter horizons are more consistent with less volatile asset allocations than are longer horizons. As well, clients’ financial and personal circumstances change over time, as does their risk tolerance and investment knowledge.
  6. Give the two components of risk tolerance and explain whether either of them will remain constant for any given client.
    Risk tolerance has a psychological component as well as a circumstance-related component. Since clients’ financial and personal circumstances are likely to change over time, these components will not remain constant. In addition, as clients age they tend to become less risk-tolerant and their time horizon shortens. Therefore, the psychological component is likely to change over time as well.
  7. A client wishes to purchase $5,000 worth of your institution’s equity fund but refuses to give any information other than his name and address. Would you fail to discharge any of your responsibilities if you accepted the order? If so, which one(s)?
    By accepting this client’s order, you will have failed to discharge your responsibilities: ethical, legal and professional. First, you know from this course that you must know the client in order to provide excellent client service, which is your professional responsibility. You also have the legal responsibility to only sell suitable products. However, if you do not know the client you will not know what is suitable. Your ethical responsibility is to put the interest of the client ahead of the financial institution or your own interest. Just taking an order without any consideration as to the suitability is putting the interest of your institution ahead of the client. You would be taking the funds without any regard to the suitability principle, just to ensure the sale.
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Chapter 4 - Getting to Know the Client
SUMMARY The job of an investment advisor is to judge investment suitability based on their knowledge of the client’s goals, personal circumstances, financial circumstances, time horizon, investment knowledge and risk tolerance. Financial objectives are set by clients, sometimes with the help of financial counsellors. Objectives are best stated in terms of precise financial targets, but they need not be in order for the investment advisor to be of assistance. The most important aspect of a financial objective is its investment horizon. Objectives can also be stated in terms of the type of return desired, such as safety of capital, current income or growth (capital gains). Financial circumstances provide an indication as to whether the client is able to attain stated goals with the financial resources available while maintaining sufficient cash reserves. Understanding clients’ net worth provides an indication of their investment knowledge and current asset allocation. Personal circumstances indicate the extent to which investors might need access to savings in order to meet family responsibilities, and the extent to which they can afford to take investment risks. Clients with a high level of investment knowledge know the mutual funds they wish to buy, their risk/return characteristics and their desired asset allocation. In addition, knowledgeable investors are also likely to have a good idea of their own level of risk tolerance. Risk tolerance has both a psychological component and a circumstance-related component. People tend to become less risk-tolerant as they age. People with family responsibilities are, because of circumstances, less inclined to take investment risk. Since investors’ personal circumstances, objectives, time horizon, financial circumstances, investment knowledge and risk tolerance change over time, it is important for the investment advisor to follow the client. Normally, clients should be requested to have their investment portfolios re-evaluated annually or sooner if circumstances change. A difficult client is one who is unwilling to provide the necessary information so that the investment advisor can judge investment suitability. In the case where sufficient information cannot be obtained, the advisor should refuse to take that client’s order.
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