Chapter 5 - Kinds of Clients

  1. A 40 year old client is married and has two children that are soon going to graduate. Asubstantial amount of their mortgage has been paid off and their disposable income hasimproved. What is their life-cycle stage?
    This client would be considered to be in stage 3, “Mature Earning Years”. One of theindicators is that the children are soon to graduate and their increasing disposable incomemeans that they can now start to focus on longer term goals.
  2. List the five life-cycle stages in order from low risk tolerance to high risk tolerance. Is there asmooth change as people age?3.
    From low to high risk tolerance, the list would be: Stage 5 (retired); Stage 2 (family commitment years); Stage 4 (nearing retirement); Stage 3 (mature earning years); and Stage 1 (early earning years). As you can see, there is not a smooth transition from Stage 1through to Stage 5, because clients in the family commitment years do not have the liquidity necessary to take investment risk.
  3. A client had an asset allocation of 60% Equity, 30% Income and 10% safety at age 50.They are now 60 years old and there have been virtually no changes in their life style orcircumstances. What can you say about their current asset allocation?
    Although there are few changes in their circumstance, the time horizon has gotten shorter by10 years. Instead of 15 years until retirement, it is more likely to be 5 years until retirement. During this time they will have gone from stage 3 to stage 4. As the time horizon gets shorter, we know that the risk tolerance should also decrease. Therefore, the current asset allocation should have a reduced amount of equities and an increase in the amount of income and safety. The amount of decrease in risk for the asset allocation will depend upon the individuals personal risk tolerance.
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Chapter 5 - Kinds of Clients
Summary of Life-cycle Stages We can summarize the features of the life-cycle hypothesis by looking at how investment goals, personal circumstances, investment knowledge, time horizon, financial circumstances and risk tolerance change as people age. First, investment goals for Stage-1 people tend to be short-term but might also have a longer-term component. Stage-2 goals are shorter-term with a medium-term component. In Stage 3, goals are medium-term with a substantial long-term component. By Stage 4, retirement is approaching and goals tend to shift to the medium term. In retirement (Stage 5), goals are medium-term in the sense that the existing investment portfolio must continue to earn income over the medium term. Second, stage 1 clients have no family constraints. They become very heavy in Stage 2. By Stage 3, these commitments have moderated to a certain extent. In Stage 4, family commitments are once again light. Stage 5 might see an increase in family commitments to help grandchildren. Third, as far as financial circumstances are concerned, Stage-1 clients tend to have a small investment portfolio and small financial commitments, such as car payments. Stage-2 clients might find that whatever they have been able to save in Stage 1 might be needed due to substantial Stage-2 financial burdens, such as mortgage payments and possibly family expenses. They tend to have little liquidity. By Stage 3, financial circumstances have greatly improved. It is during Stage 3 that most of the increase in a client’s wealth will occur. More attention must be devoted at that point to attaining an asset allocation in keeping with the client’s level of risk tolerance. Stage-4 clients have substantial investment portfolios with little in the way of day-to-day liquidity requirements. Retired clients’ financial commitments are light and their portfolios must be able to maintain living standards. Finally, risk tolerance changes with age. Young people are more psychologically able to bear risk. This willingness to bear risk declines with age, since as the time horizon shortens, the level of risk tolerance decreases. Asset allocations vary with each changing stage and are affected by all of the constraints indicated above. However, it is important to note that the single most important determinant of clients’ asset allocations at any stage is their psychological ability to bear risk. There are some retirees who have a very high tolerance for risk and some 25-year-olds who do not. As a result, there are some retirees with investment portfolios containing a substantial equity fund component and some much younger investors who refuse to invest in anything other than money market funds. The life-cycle Hypothesis Is not Perfect Using the life-cycle stage as a tool for understanding clients is also made much more complicated in cases of single-parent households. Single parents must manage with one salary even though support payments might be available. One could argue that the asset allocation for single parents should correspond to the lack of income support (by way of a second salary); that is, the investment portfolio should be lower in risk. You should use the life-cycle hypothesis as a tool in understanding clients’ overall needs. At the same time, you should listen carefully to what your clients have to say. You might find that the hypothesis is not always of use.