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8 - Chapter 8 Copyright© 2011 Money Education LLC Chapter...

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Copyright© 2011 Money Education, LLC Chapter 8 Chapter 8 Introduction Copyright© 2011 Money Education, LLC Chapter 8 2 Investing is the process whereby capital resources are allocated and committed by investors with the expectation of earning a future positive economic return. The overall return investors expect is primarily a function of the riskiness of the investment. Returns can be in the form of current income (interest or dividends) and/or capital appreciation. To achieve the investment goals, the client is expected to invest at a risk level consistent with an assessment of his risk tolerance. Risk Tolerance (Ability) One’s ability to take on investment risk is a function of objective measures such as: Investment goals Time horizon for each goal Need for liquidity Client’s tax situation Unique circumstances Copyright© 2011 Money Education, LLC 3 Chapter 8
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Risk Tolerance Questionnaire (Willingness) The risk tolerance questionnaire evaluates a client’s willingness to take on risk by inquiring about risk issues. The questionnaire can help the planner determine whether the client is physiologically risk averse or risk tolerant. A risk averse investor requires significantly more return in order to consider investing in a higher risk investment. A risk tolerant investor is more willing to accept risk, for a small increase in return. Copyright© 2011 Money Education, LLC 4 Chapter 8 Risk Tolerance Questionnaire (1 of 2) Copyright© 2011 Money Education, LLC 5 Chapter 8 Risk Tolerance Questionnaire (2 of 2) Copyright© 2011 Money Education, LLC 6 Chapter 8
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Risk Tolerance Questionnaire (Willingness) If the client’s ability to take on investment risk is higher than the client’s willingness: If the client’s ability to take on investment risk is lower than the client’s willingness: Only when the client’s willingness and ability are equal does the financial planner proceed to develop an investment strategy. Copyright© 2011 Money Education, LLC 7 Chapter 8 Ability Willingness Low Medium High Ability Willingness Low Medium High Expected Return Expected return is the compound annual rate of return expected for an asset or investment portfolio. It is primarily a function of the riskiness of the investment(s). Copyright© 2011 Money Education, LLC 8 Chapter 8 Historical Risk and Return Relationship Between Equities, Bonds, and Treasury Bills 1900 – 2008 Return Risk* (Standard Deviation) Range of Expected Annual Returns Equities 11.2% 20.2% -29.2 to 51.6 Government Bonds 5.5% 8.3% -11.1 to 22.1 Government Bills 4.0% 2.8% -1.6 to 9.6 Inflation 3.1% 4.9% -6.7 to 12.9 *Expected return in a normal market in a year range by 2 standard deviations + / -. The Investment Planning Process The investment planning process is a series of steps the financial planner and client follow to build an investment portfolio designed to achieve the client’ s investment goals.
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