How Financial Advisors Determine Your Investment Suitability
There are certain factors that financial advisors and portfolio managers take into account when trying to determine what financial and/or physical assets is suitable to constitute each individual’s investment portfolio and the suitable time horizon of the assets. Physical assets include assets such as real estate and commodities which could be included in the client’s investment portfolio using contracts or pooled investment vehicles.
One of the most important determinants of asset allocation is the client’s AGE. Age is generally bracketed into four different groups based loosely on how much risk the people in the groupings should be taking. Younger people have more time to recoup their loses and so will be able to take more risk than older people whose sole aim is to have a steady income in retirement. The first group includes recent graduates- they are earning little compared to what they will be earning in the future and are at the stage of planning to have a family. These people would be able to take on more risk and so the bulk of their portfolio will be equities- all other things being ignored. The second age group are middle aged professionals- mostly in their thirties and forties with children. The third group are people who have reached the peak of the career- and earnings-, and the last group are those in retirement age. Based on where individuals fall in this grouping, portfolio managers will decide on the class of assets that will best suit their clients’ respective situations, and the weightings of these assets. Typically, and as an example of how this works, the portfolio of people in retirement will be weighted more heavily towards fixed income securities than that of new graduates.
Risk tolerance is arguably the most important factor after age. Although it is important to know how much risk a person CAN take, the amount of risk they are WILLING TO take is just as important. Risk tolerance obviously varies among individuals, and it has its roots in the psychology of each person. One interesting factor related to risk tolerance is the source of the funds to be invested. People are willing to take more risk on money they inherited or won for instance than on money they worked for- the result of a psychological phenomenon that results in the thinking that not all cash is equal.
Although it is usually the case that people are investing towards retirement, portfolio managers and financial advisors would have to find out what the individual is investing for- their investment goal. It is possible that a person is investing for the purpose of buying a house or car for instance, or saving for their children’s college tuition. Knowing this will also help the portfolio manager determine the adequate time horizon of investments so that he can ease up on the amount of risk being taken as the time for withdrawal of funds approaches.
Tax is an important source of cash outflow for investors, so the client’s tax bracket, and whether people hold their portfolio in a tax deferred account are of great importance. Retirement accounts such as the RRSP (Canada) and 401k (U.S) for example are tax deferred accounts and returns and income earned on portfolios held within these retirement accounts will only be taxed upon withdrawal.
Finally, an individual’s investment knowledge determines how much risk will be taken on their investment portfolio. It is important that the client understands the upsides and downsides of investing in certain assets, and knowing that the client understands this makes it easier for the portfolio manager to take the client’s financial asset recommendations into account.