Posted by Hi everyone. Thanks for dropping by the Coach’s Hangout. It seems no matter what course you’re taking, whether it be mutual funds, securities LLQP, WME, FP2, you name it, you could be presented with a client scenario like this one [seen in video] and asked “What Asset Mix would you recommend to the client?” And I know what lots of you are thinking …
“A recommended the asset mix, but how? I’m still studying and I’ve never even had a client”.
Well, don’t worry, in today’s video I’m going to give you three easy tips to help you answer these types of questions. Now, full disclosure. I’m going to assume that you already understand the risk-reward relationship, and you know that the asset mix or asset allocation simply refers to how much of the portfolio is allocated to each category of investments with a main categories, being cash and equivalents, fixed income and equity. If you need a refresher checkout the 19 video playlist on our YouTube channel called Investment Basics.
All right, let’s look at the question together [seen on the video]. Darcy is 35 years old and saving for retirement. She has $200,000 saved in her RRSP and will contribute the maximum each year. Her portfolio consists of Treasury bills, fixed income mutual funds, equity mutual funds, and a few individual stocks. This suggests to me she is somewhat comfortable with risk. Her husband, David, does not contribute to an RRSP, but has an excellent pension at work. What asset mix would you recommend to Darcy? Now I acknowledge there isn’t too much info here. It’s only one paragraph. I wish there was an answer ‘e’ that said something like “Have a thorough conversation with Darcy before making a recommendation”, but that isn’t the case. Get used to it. You’re going to have to pick the best answer. In the real world though you will get to have a conversation with the client.
Here are three tips that will help you pick the best answer.
Tip #1: Ask yourself, “Are there any red flags that would stand out that would alter the asset mix you would otherwise recommend?”
For example, if the scenario said Darcy was going to be using the money to buy a house in the next year, with such a short time horizon, it probably wouldn’t be appropriate to hold equities. Her portfolio should be in cash and equivalents. So answer ‘a’ would be a good answer. If that were the case, or if she was saving for retirement, or extremely risk averse, perhaps she would have very little equities despite being quite young. Now there are no red flags in this scenario, so let’s move on to Tip #2.
Tip #2: Eliminate any answers that have more than 10% in cash unless justifiable based on the scenario.
While an investor may want to keep some cash on hand for emergencies or investment opportunities that could arise, cash doesn’t generate much of a return. For this reason, a long-term oriented portfolio should typically have between 5 to 10% cash. If there isn’t something in a scenario to justify having more, you can use this to eliminate answers. With this in mind, it’s probably safe to eliminate answer ‘d’ which allocates 20% to cash.
I’ve saved the best tip for last.
Tip #3: Use the age approach, often referred to as the “Rule of 100”, to determine an appropriate percentage of equities.
Now, I hate the name “Rule of 100”. It’s not really a rule at all. It’s only a guideline. So I call it the “Suggested Guideline of 100”, and it works like this. Take the number 100, subtract the person’s age, and that gives you a suggestion as to what percentage of equities might be appropriate. Again, assuming there were no red flags, as discussed in Tip #1. A few examples will clarify.
If the investor is 20, the guideline of 100 would suggest 80% equities, 100 – 20 = 80 … and this makes sense. A long-time horizon means the young investor could likely assume more risk.
What if the investor is 50? Well, the guideline of 100 would suggest 50% equities, 100 – 50 = 50. This makes sense, too. The person is older and may want a less aggressive portfolio.
Now, what if the investor is 80? The guideline of 100, would suggest only 20% equities. 100 – 80 = 20. This makes sense. Being 80 years old would suggest that a less aggressive portfolio is likely appropriate.
So in this question, Darcy is 35. If we take 100 – 35 , it suggests approximately 65% in equities may be appropriate. Let’s keep this in mind.
Now let’s circle back to the question. We can eliminate the answer ‘a’ because100% cash is too much. You can eliminate answer ‘d’ because even 20% cash is too much. Remember the guideline of 100 suggested 65% equities. We can eliminate answer ‘b’ as the cash is a little high and the equities are a little low. Answer ‘c’ looks pretty good though. 8% cash is acceptable. 67% equities looks about right, and that leaves 25% remaining for fixed income. So, let’s select answer ‘c’, and, of course, we are correct.
Remember, in the real world, you’re going to need to understand your clients’ goals, dreams, fears, risk tolerance, etc., before making recommendations. But when it comes to the exam, these tips will help eliminate answers and whittle it down to the best answer. Thanks for dropping by the Coach’s Hangout.