Private Client Investment Advice Flashcards

When constructing an investment portfolio for a private client, what is the primary purpose of 'asset allocation'?

Answer: To determine the proportion of a portfolio invested across different asset classes to optimise the risk-return trade-off based on the client's objectives and risk profile

Asset allocation is the process of dividing a portfolio among different asset classes (equities, bonds, property, cash, alternatives) based on the client's objectives, time horizon, risk tolerance, and capacity for loss. Research consistently shows that asset allocation is the primary determinant of portfolio returns (often cited as explaining over 90% of return variation). Strategic asset allocation sets long-term targets; tactical allocation makes short-term adjustments based on market views.

A client aged 40 with a high risk tolerance and a 25-year investment horizon is saving for retirement. Which asset allocation is MOST appropriate?

Answer: 70-80% equities (globally diversified), 15-20% bonds, 5-10% alternatives

A 40-year-old with high risk tolerance and a 25-year horizon can afford significant equity exposure, as the long time horizon allows recovery from short-term volatility. A globally diversified equity-heavy allocation (70-80%) provides the best growth potential over 25 years. Bonds (15-20%) provide some stability and income. A small alternatives allocation (5-10%) adds diversification. 100% equities would ignore the benefit of diversification, while heavy bond or cash allocations would likely underperform over this time frame.

What is the purpose of 'rebalancing' a client's investment portfolio?

Answer: To restore the portfolio to its target asset allocation after market movements have caused drift, maintaining the intended risk level

Rebalancing involves buying and selling assets to restore the portfolio to its target asset allocation after market movements cause drift. For example, if equities outperform and grow from 60% to 70% of the portfolio, rebalancing sells some equities and buys other assets to return to 60%. This maintains the client's intended risk level, enforces a disciplined 'sell high, buy low' approach, and prevents concentration risk. Common approaches include calendar-based (e.g., quarterly) or threshold-based (e.g., when any asset class drifts more than 5%).

A client receives a £500,000 inheritance and wants to invest it all immediately. What should the adviser consider recommending regarding the timing of investment?

Answer: Consider phasing the investment over several months to reduce the risk of investing at a market peak

While academic evidence suggests lump sum investing often outperforms phased investment over time, phasing (drip-feeding) over 6-12 months can reduce the psychological and financial impact of investing at a market peak. For a large lump sum like £500,000, phasing provides pound cost averaging benefits and allows the client to adjust if circumstances change. The adviser should discuss both approaches, considering the client's risk tolerance, capacity for loss, and emotional comfort. The recommendation should be documented in the suitability report.

What is the primary purpose of a 'suitability report' in the context of investment advice?

Answer: To document why the personal recommendation is suitable for the client, demonstrating that their circumstances, objectives, and risk profile have been considered

Under COBS 9.4, a suitability report must be provided to a retail client before a personal recommendation is implemented. It must explain why the recommendation is suitable for the specific client, referencing their objectives, financial situation, risk tolerance, capacity for loss, and knowledge/experience. It should explain any disadvantages of the recommendation and why alternatives were not selected. The suitability report is a key compliance document and provides evidence of the adviser's due diligence.

When advising a client who is approaching retirement, why might an adviser recommend a gradual shift from equities to bonds and cash?

Answer: To reduce portfolio volatility and sequencing risk as the client's time horizon shortens and they approach the point of drawing income

As a client approaches retirement, their time horizon for recovering from market falls shortens significantly. A gradual 'lifestyling' or 'de-risking' shift from growth assets (equities) to more stable assets (bonds, cash) reduces portfolio volatility at the critical point when the client begins drawing income. This specifically addresses sequencing risk — the danger that poor returns early in retirement permanently impair the portfolio. The pace and extent of de-risking depend on whether the client plans to purchase an annuity or enter drawdown.