Feature

posted 4 Feb 2004 in Volume 9 Issue 2

ECA course: Part four
The basics of financial planning

All solicitors and those others involved in elder care need to have an awareness of how finance plans are or should be put together. Michael Hague continues his explanation of relevant subjects with this article covering planning investments.

Planning investments

Buy low and sell high. Is that all there is to investment planning? Well, if you could get it right all the time, you would not need to be an investor – you would be a very rich speculator. Investors and speculators are not the same thing.

Speculators do not seek to participate in the wealth created by successful business or other activities. They seek to benefit, at a cost to someone else, from usually short-term movement in the price of something. As an example, if you believe that Marks & Spencer has a good base of assets from which it will be able to successfully design, produce and sell a range of products at a profit, then you might invest in their shares. You expect to get a share of the profits in the form of a dividend and get an increase in the value of your investment as their asset base and future-earnings expectation grows.

If, on the other hand, you hear that Wal-Mart is intending to bid for Marks & Spencer and think that will push its share price up, then you might speculate on some of their shares. You aim to sell them on to Wal-Mart or some other investor and realise a short-term profit.

Investors share in the wealth created future successful trading. The speculator might make money (if he gets it right) but no wealth was created – just taken from someone else.

We do have clients who get involved in speculation. By and large they do this for themselves, though we might establish tax-efficient structures and easy-dealing systems for them. It is usually only a small part of their overall portfolio and, it has to be said, some of them have done particularly well with what they refer to as their “play pot”. It also has to be said that the bursting of the technology bubble in 2000 turned a number of speculators back into investors – and cautious ones at that.

So, if the majority of clients are investors, not speculators, how do you prepare and implement an investment programme for them? Figure one gives an outline of the investment-planning process – albeit in a simplified form. In this, the first of two parts to the investment-planning element of this course, I will be dealing with the first stages of the process. Some of the elements have been covered in earlier articles, so I will refer you back to them rather than restate all the detail here.

Figure one: The investment process

Identify your objectives;
Identify the resources you have available;
Specify the risks you are willing to take;
Prepare a plan;
Test risk tolerance;
Set the asset allocation;
Populate the model;
The investment process.

Setting objectives

I always feel it helps to work an example alongside the theory, so let’s go back to John and Jill, who we met in the first article. Just to remind you, he is aged 75 and she is 74. They are married and in reasonable health for their age. They gave us a list of objectives, which I have shown in figure two. These need quantifying, which we said had been done by analysis of current spending patterns, to give £26,000 pa to cover their regular spending. Their car changes tend to cost about £8,000 each time and they want to give £5,000 to each of the grandchildren.

While we might want to establish more detailed information on some of these objectives, I would feel comfortable using this amount of information as sufficient for the objectives part of the process.

Figure two: John and Jill’s objectives

To make sure they can maintain their standard of living;
Change the car every three years until they are about 85;
Give their three grandchildren some money when they graduate;
Make good use of their money without having to worry about the investment markets too much;
Make sure they are each financially independent on the death of the other;
To pass money on to their children and grandchildren;
Be financially efficient in terms of the tax they pay, the investment return they get and the level of charges they pay.

Identifying resources available

John and Jill have £200,000 of investment capital and a mixture of state pension and private pensions. In part two of this article, when we look at asset allocations, selecting specific holdings and tax-efficient structures, we will see that knowing the make up and ownership of these resources is important but, for the purposes of part one, this is sufficient detail.

Specifying risks you are willing to take

Now we come to a new topic for this financial-planning course: specifying the risks you are willing to take.

This is something that has been thrown in to sharp focus in the past three years. Advisers have asked their clients how they feel about investment risks only to be faced with blank or exasperated faces. Faced with this, advisers have talked in terms of low, medium and high risk. Some have gone on to develop word pictures which, supposedly, help the client understand the issues. But do they?

When we meet clients for the first time, we explain to them that we will be asking them to complete a risk-tolerance questionnaire (more on that in a moment) and that we will also be comparing their current investments to their risk-tolerance results. We repeatedly hear how they have either not been asked about their attitude to risk or how they feel they did not really understand the questions their adviser asked about risk. For example, think about the client who said that he always thought high risk sounded dangerous; that if he said he was low risk then the adviser might think he was “a bit of a wuss” – so he thought he must be medium risk!

Faced with a medium-risk answer, the adviser might believe he was right to recommend a general managed investment, such as an insurance company managed fund or a managed unit trust. After all, he views those as medium risk.

Well, Standard & Poors has recently re-vamped its website (www.funds-sp.co.uk) to give more information about a whole range of collective investments. From these I can see that, over the past three years, the asset-allocation sector has:

Averaged a loss of 4.41 per cent pa;
Had a volatility of 13.2 per cent either side of that average (so good times were ups of 8.79 per cent and the bad were downs of 17.61 per cent);
If you picked the worst period, a drop in value of 28.92 per cent.

That might be what the adviser understands as being medium risk but is it what the client meant?

Before someone starts to point out that, in the long term, such funds have produced average returns that beat inflation and outperformed deposit accounts and other lower-risk investments, think about this. Would you wade across a river if you were told its average depth was just 4ft? Chances are you would also like to know what the maximum depth was going to be and how strong the currents were in that area, so you knew what survival equipment you needed to take with you.

A fund that has produced good long-term averages but had some rapid and deep falls may also need you to be equipped with some good financial-survival equipment.

So, how might you approach the need to measure risk tolerance for a client? After much research, our firm has settled on the use of ProQuest, an Australian company that has developed a risk-tolerance questionnaire to psychometric testing standards and then linked this to back-tested portfolios that use a mixture of different asset classes. These show clients the return they might expect as a result of taking a particular level of investment risk, expressed as a multiple of term deposit accounts, but also the size of falls such portfolios have experienced while earning that return and the length of time it has taken for the portfolio to recover from those falls.

ProQuest is active in Australia, New Zealand and the USA, and is developing an offering in the UK. The client questionnaire is the same for each country as tolerance to risk has not been found to differ between them. What does differ is the structure of the portfolio you would want to use to meet a client’s needs. US, UK and Australian investors need to weight their portfolios differently to allow for currency differences and more developed asset classes being available in their domestic market. For example, UK investors have access to a sophisticated commercial property marked that is not as readily available in Australia. US investors will want to have their largest equity holdings in the Dow Jones companies, but that would represent an unduly high currency risk for UK or Australian investors, who would want to invest in the FTSE companies or Australian All Share respectively.

We have looked at a wide range of other systems but find ProQuest to be the most detailed and well-thought out. Others suffer from a lack of detail or are couched in terms that seem to steer the client towards an investment choice – usually one that falls in the range of the company offering the questionnaire. I know that other methodologies will work but, if you want to look at a well-formed risk-tolerance measurement system, then I suggest you start with the information given by ProQuest.

This is not the end of risk-tolerance questions. ProQuest has measured the client’s tolerance to risk – but what is his plan’s tolerance to risk? What do you do if the client’s risk tolerance score is low – but his plan won’t work with the low level of return anticipated from such a conservative investment strategy?

The first step is to build a plan to see what can be achieved

Prepare a plan

We did this for John and Jill in the first article. We now need to do some testing of it to see how risk tolerant it is. Before we do so, a word about the range of plans we have to deal with.

Achieving or maintaining financial independence is an objective of just about every client. However, each has a different set of resources with which to plan for this. This, in turn, impacts on the format of the investment programme and the degree of risk the plan can tolerate.

In an ideal world, all clients would have enough money to be able to invest it and live on the income from those investments. By income, I mean true investment income such as yield from gilts (preferably index-linked gilts to counter inflation), rent from property or dividends from shares. This would then leave growth in the capital element of the portfolio (such as increasing property values or share prices) to help the value at least keep pace with inflation and, preferably, to grow in real terms. This is the ideal and ultimate level of financial independence – the client enjoys a high degree of security, the portfolio is likely to survive severe market fluctuations and, apart from keeping some liquidity for emergency or opportunity spending, the planner can build a portfolio for the whole of the capital within the level of risk specified by the client.

In reality, most clients need more than just the income from their investments. They need to draw on a combination of income and capital growth in order to meet their needs. We refer to this as needing a total return. If the total return is sufficient to maintain the capital value (in either real or nominal terms) after meeting spending needs than the plan is in balance.

If total return is not enough to meet spending needs then the client needs to add in an element of spending their capital. This is not a problem provided they don’t live longer than their money lasts.

John and Jill’s plan in article one did show some growth, but this was mostly in the later years and only if they did not need to pay for long-term care.

In the early years, they need to spend all the total return. This needs careful planning because, while income can be predicted, capital growth is less so. An investment portfolio might have an average return of 8 per cent pa, but a standard deviation of, say 10 per cent. This means that the return has been as high as 18 per cent but as low as -2 per cent. If you had planned to take 8 per cent income then you could be heading for trouble. This is especially true if you take income out first in anticipation of total return, and even more so if the portfolio has low returns in the early years.

A more effective way to use money The solution in these circumstances is to plan to have money prepared for spending. There are a number of techniques for achieving this. A much favoured one is to have a plan which puts:

Money on deposit to cover spending in years one and two, along with an emergency fund. Income is paid into this account and all spending goes out from it;
Money needed for spending in years 3,4,5,6 and 7 (and 8 and 9 if you want to be particularly conservative) into secure investments with a level of investment return known at outset (guaranteed investments, gilts, national savings bonds, etc.);
The remainder of the money in a portfolio in line your risk tolerance.

There is then a need to move money from the portfolio to the guaranteed investments and on into the cash accounts each year ready for spending.

John and Jill’s plan in article one was prepared on this basis and started with about £13,900 on deposit, £39,000 in guaranteed investments and the remaining £147,100 in a portfolio of investments.

The level of risk needed by the plan

However, this was based on an assumed rate of investment return. When that article was written the return was roughly that of an investor in risk group four – the middle of the ProQuest groups. Since then, more of the current market conditions are reflected in the figures and the return assumed would have been nearer to risk group five. This brings us to the risk-tolerance testing phase of the plan.

In the last article, I gave a range of assumed investment returns based on risk tolerance. These are not the latest set but I will continue to use them in order to maintain continuity. If John and Jill agreed they were risk tolerance group one then their plan still works – but just not as well as it did before.

In their case, the plan will pass the risk-tolerance testing. If they were tested risk group four then we need to tell them they need not take that level of risk. The choice remains theirs but they need to know that taking an increased level of risk is something they are choosing to do, rather than being necessary for their plan to work. Conversely, if they took more risk, say moving into risk group five, the plan will show an increase in its final value but not sufficient to make a great deal of difference. Would it really be worth the additional worry of taking higher risk? Probably not.

What if it goes wrong?

Next, you need to see if the plan will still work if investment risk results in losses of the size experienced by investors in this risk group. There are a number of sophisticated techniques for modelling this but a simple test is to reduce the opening capital by the maximum loss shown for the risk group. This simulates what would happen if there was a severe fall in value immediately after the plan was implemented.

John & Jill’s portfolio passes this test – the plan still works if there is a loss in the first year equal to the biggest loss experienced in the past.

What if the risk level is wrong?

John and Jill’s plan will work using an assumed rate of return, which is in line with that achieved by portfolios designed to be in line with their risk tolerance. What’s more, the plan is tolerant to a level of risk equal to that they have been tested as being tolerant to themselves. This is a very satisfactory state of affairs but what if the outcomes are different? What if the plan needs more return than the client’s risk tolerance? The client has to make a choice:

Reduce their objective, for example: – Live on less money in retirement; – Defer retirement;
Add more resources, for example, my favourite, guaranteed financial-planning technique:
– Earn more;
– Spend less;
– Save up the difference;
Take more risk.

In these circumstances, you can permit a plan to proceed taking a lower degree than is needed, rather than insist a higher level of risk is taken from the outset. Taking less risk for the first few years of a plan is unlikely to stop the plan working, whereas taking too much risk, and losing money as a result, might just make it impossible to recover sufficiently to make the plan work in the future.

What if the client’s risk tolerance is greater than that needed by the plan? Again, the client has to make a choice:

Seek bigger objectives, for example:
– Target a higher income in retirement;
– Retire early;
Reduce current savings:
– Reduce work commitments;
– Spend more;
Take less risk – perhaps sleep better.

End of phase one

Having:

Established the objectives;
Measured the current position;
Built a model;
Specified the level of risk;
Built a model;
Tested:
– Client’s tolerance to risk;
– Plan’s tolerance to risk.

We are now in a position to start building the portfolio. In the next article, I will look at the steps needed to build the portfolio to take the £13,900 needed to cover immediate spending needs, the £39,000 needed in the medium term and the £147,100, which needs to grow for the later years.

Phase two

In part two of planning investments, I will look at the remaining elements of the investment process, including asset allocation, choosing holdings, market timing, and wrapping things up tax efficiently. Life-time cashflows and risk tolerances are complex, but can be completed relatively quickly. These remaining elements of the process seem never-ending and take up a lot of time. It is essential that you have grasped part one before you go on to start part two.

Michael Hague is a partner in The Consultancy Group. He can be contacted at: michael.hague@theconsultancygroup.com