Wealth Management and Diversification of Investment - Essay Example

WEALTH MANAGEMENT and Requirement One According to Richard Pike (2002), 2nd Edition wealth management involves proper financial planning, prudent investment decisions in terms of investment portfolio management to achieve the highest return on investment and reduce the financial risks associated with the respective investments opportunities in the market. Investment involves allocation of funds among investment projects in expectation of future cash inflows from the investment projects (PANDEY, 1979). Investment managers are therefore expected to make long term decisions and to make prudent financial decisions which serve the interest of the investors. The wealth of the business or investors will depend on the future cash flows that are expected from the investments. The decision makers should know the degree of risk associated with a given investment option that is to be taken. Various investors have different attitudes towards risk and they would want to invest in an efficient portfolio. An efficient portfolio refers to a portfolio that provides the highest returns than other portfolio at the same risk or least risk at the same level of return (GOEL, 2009). Every investor would want to maximize on the investment by diversifying any risks that may affect his/her income and should be able to achieve the highest rate of return. Wealth managers should develop proper strategies that can ensure income growth, reduce business risks and low tax rates. Portfolio theory has got certain limitations when used to analyze business risks. When we talk about risk, we refer to the unique consequences for any investment decision made which can be sorted out using probabilities. Business managers mostly would want to reduce risk to minimal levels based on the concept of diminishing marginal utility which says that as wealth grows, marginal utility declines at an increasing rate. There are various types of risks that must be considred when evaluating investment opportunities.the risks include: i) Business riks – This involves the variability in operating cash flows or profits before interest. This will largely depend on the prevailing economic situations in the market. ii) The other aspect of risk that managers must look into is Financial risk which involves use of debt capital. This is increased by issuing more debts thereby incurring more fixed interest charges resulting into variability in net earnings iii) Portfolio risk investment can be reduced by significantly holding selected investments in a portfolio. This is called specific relevant risk because the element of risk should be considered by a well diversified risk. There are ways of measuring risks and these include : Scenario analysis which takes into consideration the effects of changes in key variables one at a time.It seeks to establish worst and best scenarios so that the whole range of possible outcomes can be considered. Simulation analysis is an extension of scenario analysis which is an operations technique involving various business applications. It gives possible combinations of variables according to pre-specified probability distribution. Each scenario would then give rise to an net present value outcome which ultimately gives probability distribution of outcomes. Certainty equivalent methods which allows for the incorporating the decision makers risk attitude into capital investment decision. It adjusts the numerator in the calculation of net present value computation by multiplying the expected annual cash flows by certainty equivalent coefficient. The other aspect of risk measurement is the standard eiviation which has the following limitations It considers total risks as measured by standard deviation It uses historical data and the probabilities are subjectively determined It assumes that there are no economies of scales and thus expected return on portfolio is simply the weighted average of individual securities expected returns The use of indifference curves to measure the utility of individual investor is not practical It assumes that the investment in the market are divisible The available investment options that the investor needs advice on can be discussed as follows: Offshore equity funds Offshore equity fund is a collection of investment in a financial market which is nit within the jurisdiction of one’s country. The offshore funds are governed by rules relating to offshore investments. Investors involved in offshore investment activities seek to achieve security for their investments and growth in income. Offshore involves a wide range of investments which include offshore redemption policies, offshore bonds, and offshore unit trust. Offshore funds offer several benefits to an investor which includes: Tax advantages – The regulations regarding offshore investments offer protection against exploitation for legal tax. The lower tax makes the investments more attractive to foreigners. At the same time taxation can be deferred by rolling over of investment income to allow tax planning. Diversification of investment – Risk can be diversified by investing in a wider range of investment options available in offshore investments. Low level of regulation – There are a number of investments that operate within the low regulatory environment due to their aggressive strategies. The management cost of the investment is lower as compared to investing in own country Specialized financial services – the offshore centers have well developed financial services which provide advice on fund management, banking , insurance and legal services Despite the benefits of offshore investments there are arguments against offshore investments. These include the following: Offshore investment reduces transparency to regulators of financial transactions in a country. Lack of transparency can accommodate such illegal activities like money laundering and tax evasion by the investors. Investors may take advantage created to earn wealth by a taxed economy and avoid paying tax obligation in full in that economy. Wealth earned from that economy cannot be taxed again when spent to provide services and other developments. Corporate Bond Funds Corporate bond are funds that are invested in diversified portfolio and therefore have less risk of default (EVENSKY, 1997). The portfolios are diversified among various individual securities in the market. They therefore give the investor steady monthly income through well managed portfolio and at the same time the fund has access to global bond market which is designed for investors seeking fund liquidity. Bond funds are sensitive to interest rate risk and have no maturity date which in return can make them lose value and result into investor not able to receive all of their principal amounts back in the future. At the same time the gearing and liquidity can pose risk challenges to bond fund. The income received in the form of interest is taxable by the government at the rate prescribed by the government in the country where the bond investments operate. Investing in corporate bond funds has the following advantages They have the potential of high returns and this culminates into capital growth as compared to government bonds or term deposits. The portfolio is highly diversified because the investments involve a wide range of opportunities in the bond market which reduce risk and broaden opportunities. Investing in corporate bonds give competitive edge through venturing into offshore markets which allows the investors to get best priced opportunities in the offshore markets. Management is done by fund managers who provide expertise to investors regarding issuer worthiness, bond maturity, pricing, and coupon and yield rates. There are opportunities for reinvestment of income earned by rolling over and hence addition to the value of the fund. Investors can improve their liquidity by selling the shares in bond fund at any time without regard to maturity of the bond. Corporate bond funds have some disadvantages as well and these include such costs as fees which are charged as a percentage of the total investment. Again dividends also vary since interest payments rates are not fixed as it happens with individually held bonds. Authorized investment funds This is a form of pooling of resources together and putting in collective investment scheme is a form of investment fund by a number of investors (SHAH, 2007). The investment funds are normally professionally managed portfolio of investments which are in the form of gilts, bonds, equities and property. They include the following types of investments: Authorised Investment Funds Authorised Unit Trusts Open Ended Investment Companies Property Authorised Investment Funds Qualified Investor Schemes Tax Elected Funds Authorised Contractual Schemes This type of investment also takes into account the diversification of risk because it can be undertaken in various types of authorised investment funds. It does not require huge investment because the resources are pooled together from different individuals and entities (LASHER, 2010). The funds are managed by experts who offer advice where necessary. This type of investment can boost the liquidity of investor by investing in liquid real estate hence boosting capital growth. Income earned from such investment is taxable at the prevailing tax rates. The funds are highly regulated and investors have to comply with investment conditions. Capital gains a rising from such investments cannot be distributed unless through redemption by an investor (HALLMAN, 2008). Index – Linked Gilts These are forms of borrowing by the government where the government in return for lending of the money pays an annual rate of interest or coupon until such a time the government returns the money at a future date (EVENSKY, 1997). The interest rates and redemption values rise depending on the rate of inflation based on the retail price index. The fact that inflation is considered makes the investment attractive to investors taking into account that the government honours its obligation or commitment (SWART, 2002). National Savings Index-Linked Certificates pay a fixed rate of interest over and above retail price index, tax-free, for either three or five years. Even though the initial investment is not inflation-linked, the tax-free benefit makes these attractive for higher rate taxpayers. The other aspect of such investment is the diversification in various equities. Having exposure to index-linked gilts can be regarded as a good way for fund managers to smooth out some of the volatility in returns experienced by an equity portfolio. Such a strategy would provide benefits when investor sentiment in the economic outlook turns negative and equity performance suffers (HALLMAN, 2008). Index-linked gilts form a key element of the portfolio strategy, due to their distinct risk/return characteristics. Not only do they offer returns that rise in line with inflation but their low performance correlation with other major asset classes means they are an excellent source of portfolio diversification (SWANSBURG, 1997). Indexed – Linked Gilts have greater growth potential because the interest rates are not fixed as opposed to other bonds but would be high if there is improvement in the financial sector leading to increase in the value of the Gilts (VENTO, 2013). The bond value can be affected if the financial market is performing poorly and the financial index does not increase much in the course of the year. Investment advice and conclusion Since the couple is willing to combine the investments in a portfolio, this is well informed following the basic principle of diversification that was developed by Markowitz (1952). This is to ensure that not all eggs are put in the same basket to reduce risks associated with investment. Within this approach diversification decisions would be the best strategy to use as armoury for dealing with risks (BRIGHAM, (2012). The investor should therefore take bold step to combine all the investments in a portfolio because all of them are good and are well diversified to protect against risks, ensure growth and liquidity through high returns (FINNEY, 2008). ). The investment options are all diversified to build portfolio security of business activities and individual build portfolio of securities.The diversification will reduce reduce fluctuations in returns. The expected returns from a portfolio is weighted average of the return expected from its components . That is achieved through the use of proportion of the capital employed. Requirement Two The couple in this case is willing to combine the investments in a portfolio, this will be able to meet the needs of Katia and Kevin. The couple would like to be able to fund their children’s university fees and at the same time be able to purchase a holiday home in North Wales. As people who are saving hard for their retirement plan, it is expected that they will be very conscious of the need to protect their investment. For this reason, it is best that they choose this investment choice so that they can be able to spread their risks and not depend on one investment (HAGIN, 2004). The investor should take bold step to combine all the investments in a portfolio because all of them are good and are well diversified to protect against risks, ensure growth and liquidity through high returns. Diversification of their investment will expose them to a different level of risk that range from low to high risk. For example, investing some money in the Index-Linked Gilts will assure the couple that their payment of income related to the principal will be related to a specific price index which is in most cases the Consumer Price Index. This will provide protection to them by shielding them from any changes in the underlying index. Corporate bond fund will on the other hand is a secure investment and, therefore, will expose the couple to a low risk. This is because they are publicly traded and, therefore, the couple can be able to know their prices at any given time. There is less uncertainty in their value. Having several investments that have different levels of risk in the same portfolio have the advantage of bringing different rates of return that depend on the current market conditions. As the market continuously fluctuates, each investment will tend to respond accordingly. This will be beneficial to the couple, especially because the markets are unstable and unpredictable. For example, when the interest rates fall, the rate of return on security investments such as the risk equity bonds will increase. On the other hand, for the higher risk equity investment, the return on equity investment increases with the increase in the market. Investing in offshore equity fund is also very profitable, but very risky at the same time (MARKOWITZ, 1991). The risk comes as a result of change in trade policy, government regulation, and taxation. The accounting standards also varies from one country to another which can as a result affect the appearance of profitability. The benefits arise because these securities tend to be less closely correlated with domestic investments. Combining all the investments in a portfolio will also increase the amount of money that was originally invested on. For example, even though investing in offshore equity fund can be very risky, this brings a higher return. (FABOZZI, 2011). Investing in different “buckets” or diversifying, the couple needs to look at the role that taxes play in this decision. This is because tax can be one of the largest annual expenses when the couple retire. Tax diversification involves investing for a greater tax efficiency by investing strategically where there are different tax treatment like tax-deductions, taxable, and tax-free. Diversifying their wealth will help the couple be able to minimize their tax obligations and at the same time be able to build greater wealth. Investing while considering the taxes is crucial considering the uncertainities that are linked to future tax rates. Diversifying their taxes through their investment decision will make sure that they promote greater efficiency during their later years. Taxable accounts like the Corporate Bond fund, may not look attractive but these accounts are key part of a well-rounded mix, These accounts provide more flexibility in terms of liquidity that they offer. On the other hand, offshore equity funds have known to traditionally have tax advantages. Combining investments will also make sure that there is a spread in the liquidity. This is because, for example, Corporate bond fund will increase the investment liquidity because these are publicly traded and, therefore, the couple can be to but and sell them in a shorter period of time (LEHMANN, 2007). i) An estimate of the final value of the portfolio at the date of retirement. It is assumed that discounting rate is 10% GBP Katia’s pension 35000 x7.6% = 2,660 Kevin’s pension 80000 x 6% = 4,800 Total savings 30,000 37,460 ======= Final value Cash flow PVAF Discounted Year Rate 0-17 37,460 8.0216 300.487 Property purchase 100,000 200,489 ======== It is estimated that the future value of total value of the total portfolio will sterlin pounds 200,489 taking into account that they will fullfill their dream in 10 years by buying property with an expected outflow of sterling pounds 100,000. ii) Computation of projected retirement income It is assumed that the Annuity Rate will be 10% FV = PV X (1 + r) = 45,000 x (1 + 0.1) = 227,451 Pounds ======= Since the couple expected to retire with a combined income of 45000 sterlin pounds . We therefore look at the future value of the expected retirement income which comes to sterlin pounds 227,451 at the time of retirement. Conclusion Diversification of investment will help Katia and Kevin be able to manage their risk. However, it is crucial for them to understand that risks can never be eliminated completely. This choice that involves diversifying their investment in different asset classes will help them find a medium between risk and return on their investment. This will assure them that they will be able to achieve their financial goal of being able to fund their children’s university fees and at the same time be able to purchase a holiday home in North Wales, as part of their retirement plan, while still getting a good night’s rest (GREER, 2003). Wealth management aims at achieving the highest return on investment and reduce the financial risks associated with the respective investments opportunities in the market. Investment involves allocation of funds among investment projects in expectation of future cash inflows from the investment projects (PANDEY, 1979). Various investors have different attitudes towards risk and they would want to invest in an efficient portfolio. A successful retirement plan requires people to develop a vision of what they want to achieve in future, in this case being buying a holiday home and being able to fund their children’s university fees and at the same time be able to purchase a holiday home in North Wales. People also need to come up with a plan and take specific steps to implement it. BIBLIOGRAPHY BRIGHAM, E. F., & HOUSTON, J. F. (2012). Fundamentals of financial management. Mason, Ohio, South-Western Cengage Learning. CHORAFAS, DIMITRUS W. (2006), Wealth Management: Private Banking Investment and Structured Financial Products. EVENSKY, H. (1997). Wealth management: the financial advisors guide to investing and managing clients assets. Chicago, Irwin Professional Pub. FABOZZI, F. J., & MARKOWITZ, H. (2011). The theory and practice of investment management asset allocation, valuation, portfolio construction, and strategies. Hoboken, N.J., John Wiley & Sons. FINNEY, M. (2008). Wealth management planning the UK tax principles. West Sussex, England, John Wiley & Sons. GOEL, M. S. (2009). Wealth management: the new business model. New Delhi, India, Global India Pub GREER, G. E., & KOLBE, P. T. (2003). Investment analysis for real estate decisions. Chicago, IL, Dearborn Real Estate Education. HAGIN, R. L. (2004). Investment Management Portfolio Diversification, Risk, and Timing--Fact and Fiction. Hoboken, John Wiley & Sons. HALLMAN, G. V., & ROSENBLOOM, J. S. (2008). Private wealth management: the complete reference for the personal financial planner. Maidenhead, McGraw-Hill Professional. LASHER, W. R. (2010). Practical financial management. Mason, OH, Thomson South-Western. LEHMANN, R. (2007). Income investing today safety and high income through diversification. Hoboken, N.J., John Wiley & Sons. MARKOWITZ, H. (1991). Portfolio selection: efficient diversification of investments. Cambridge, Mass, B. Blackwell. 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