At some point in organizations, companies, and firms may require financial support to finance their operations and maximize profits. In this case, they seek investors and potential partners interested in working with them. One way of seeking investors is to prepare investment proposals that are attractive to them and have a high potential of making good returns. An investment proposal refers to constructed presentations describing the business’s purpose, goals, and objectives to potential investors. It gives the inventors a picture of what a business does, its future plans, and its general performance. This information enables them to decide where to risk investing with a business or not, considering the potential returns of the proposed project. Therefore, this paper’s proposal aims to create an investment portfolio that generates income and maximizes returns while minimizing risks for a client. The portfolio consists of a retirement account valued at $2.5 million, where 80% allocation is for equity while 20% goes to fixed income. In addition, there is a non-retirement account valued at $2.5 million. There is no asset allocation for the non-retirement account. This investment proposal aims to provide a portfolio that aligns with the risk tolerance considering the provided financial information to ensure that the portfolio meets investment goals. Thus, the proposal provides information regarding the client’s profile, goals and objectives, risk tolerance, portfolio and derivative strategies, securities and asset allocation, taxation, risk measurement and metrics, and a portfolio forecast over the next five years.
Profile of Client
The client is an individual investor willing to spend $5 million on investments. The client has a retirement account worth $2.5 million and a non-retirement account worth $2.5 million. A retirement account is an account used by individuals to save retirement money. The funding of these accounts results from pre-tax contributions. In addition, cash withdrawal from the accounts includes a tax deduction at the ordinary income tax rate. The asset allocation of the retirement account for the client is 80% equity and 20% fixed income. It means the client is willing to take a higher risk in the retirement account to generate high returns in the long run. Generally, equity investments are more volatile than fixed-income investments. However, they are likely to provide higher returns in the long run. On the other hand, fixed investments are less volatile and provide investors with a steady income.
Regarding the non-retirement accounts, the client does not have asset allocation. It means the client has not divided investments from this account in any asset class, including stocks, bonds, and cash. However, the account is worth $2.5 million. Non-retirement account funding results from after-tax contributions. Further, they are not subject to restrictions and regulations imposed on retirement accounts. Non-retirement accounts help meet short-term financial goals such as saving for a down payment on a house or funding a child’s education. Since the client did not invest from the non-retirement account, there should not be expected returns from the accounts. Generally, the client’s profile suggests they want to generate income and maximize returns while minimizing risks. By understanding their objectives and goals, it is possible to design an investment strategy that meets their needs and aligns with their risk tolerance.
Goals and Objectives of the Client
Client’s goals and objectives are essential in designing their investment strategy. They help in meeting their specific needs. The client seeks to generate income and maximize returns while minimizing risks. Therefore, the primary objective of the client is generating income. As a retiree, the client requires a steady income to support their lifestyle now that they do not receive a monthly salary. The client wants a portfolio that can provide income. However, the client also wants to ensure that the method used to generate this income aligns with risk tolerance and minimizes the potential for causing huge losses. Another objective of the client is maximizing returns while minimizing risks. The client’s portfolio is diversified. It includes equity, fixed income, and cash. Therefore, the client wants an investment strategy to help them obtain higher returns than their current allocation. Further, they want the investment strategy to align with risk tolerance.
Thus, it is essential to account for the client’s risk tolerance when designing their investment strategy since they want to minimize the potential of experiencing significant losses when generating income. Various tools like risk management techniques can help ensure that the portfolio aligns with the objectives and risk tolerance. This way, designing a strategy that meets the client’s goals and objectives is possible and easy. Therefore, they can achieve their financial goals while managing the risks associated with their investment.
Risk Tolerance
Risk tolerance refers to the risk levels an investor is willing to withstand to achieve their investment objectives (Bodie et al., 2019). In our case, risk tolerance is an essential consideration for the client in designing an investment strategy that can meet their investment objectives with minimum risks. The client’s investment portfolio consists of equity, fixed income, and cash. The asset allocation to equity and fixed income in the retirement account is 80/20. There is more allocation to equity and less to fixed income. It means the client is willing to take a higher risk level than a conservative investor (who preserves their investment returns and invests in low-risk assets). Therefore, the risk tolerance, in this case, is moderate. Although the client is taking a higher risk level of investment, they allocate some of their investment money to a less risky asset for steady income. It shows that the client is also cautious.
Further, the client requires an investment strategy that aligns with the risk tolerance and generates higher returns than their current allocations from their non-retirement account. It means the client is still willing to take more risk to increase return but under the moderate range of risk tolerance. As mentioned earlier, some tools and techniques can help design an investment strategy that aligns with the client’s level of risk tolerance. For example, diversification and asset allocation can help manage risks and align the strategy with the client’s objectives.
Portfolio and Derivatives, Securities, and Asset Allocation
In creating an investment plan, it is imperative to consider portfolio, derivatives, and asset allocation as they play a crucial role in ensuring that the portfolio aligns with the set objectives. Utilizing a combination of strategies makes it possible to design a portfolio that generates high returns while minimizing risks and meeting the client’s goals. Asset allocation is crucial in our case, with the retirement account being 80/20 to equity and fixed income. This information, coupled with return assumptions and risk tolerance, helps design a strategy for the non-retirement account, which can have more allocation to equity. The portfolio can include individual stocks, ETFs, and bonds. Investing in high-quality stocks like blue-chip stocks is recommended, and fixed-income securities like ETFs, Treasury notes, and high-quality bonds can also be included.
Additionally, derivative strategies can be employed to generate income and manage risks, such as the short-strangle strategy on SPX (Hull 2018). The strategy involves selling out-of-the-money calls and putting options under the same security, like the S&P 500 index. Income is generated through the premiums received from selling options, while the risks are in the differences in strike prices of the selling options.
Taxation (60/40 Index Option)
Taxation of index options is a taxation method that imposes a tax on index options trading for both short-term and long-term gains, irrespective of the holding period. The United States taxation system recognizes taxes for gains and losses obtained from index options as either short-term or long-term capital gains, depending on the period of holding the options. Gains and losses for index options held for one year or less are short-term. Therefore, their taxation is under the ordinary income tax rate. Index options held for more than one year are long-term and have a low tax rate. In addition, the tax rate depends on the investor’s tax bracket. The taxation 60/40 index trading is a tax provision used to impose a tax on index options trading. The 60/40 rule provides that for any gains and losses obtained from index options trading, 60% is treated as long-term capital gains or losses, and the rest, 40%, as short-term capital gains or losses. This rule benefits investors because if an investor holds options for more than one year, they can benefit from lower long-term capital tax rates.
An example of how this rule works is; if an investor sells an index option for $10,000 and decides to hold them for 18 months, then 60% of the total gains ($6,000) will be considered long-term capital gains. Therefore, the investor’s tax rate will be under the long-term capital gains tax rate. On the other hand, 40% of the total gains ($4,000) will be considered short-term capital gains. Therefore, the investor’s tax rate will be under their ordinary income tax rate. Either way, tax rules are prone to change. Therefore, the client should consult with tax professionals to understand the tax impact of their investment decisions to help make investment decisions that maximize their returns while minimizing the tax burden.
Risk Measurement and Metrics
Risk measurement and metrics are essential in designing investment strategies, as they help evaluate potential risks associated with an investment portfolio. Various metrics can apply in this case, including Value at Risk (VaR), Sharpe, beta, and Standard deviation. These metrics measure potential loss associated with a particular investment. The first metric of this discussion is standard deviation, which measures the variability in returns. It works by representing the average difference between returns and the average returns of an investment over a given period. An investor can identify a highly risky investment with a high standard deviation. Beta is also a common metric that measures the sensitivity of investment returns concerning market movements. It works by comparing the performance of an investment to the market performance, where the beta allocated for the market is 1. More than one beta indicates the investment is more volatile than the market and vice versa.
Another metric is the Sharpe ratio, which measures the excess return of an investment per one unit of risk. When the Sharpe ratio is high, it shows a better risk-adjusted return. The last metric is the Value at Risk (VaR). It estimates potential losses associated with a particular investment, with a certain level of confidence, within a specified period. For instance, when the confidence level is 95% and the VaR is 5%, the probability that the investment will not experience a loss more significant than 5% is 95%. In summary, it is essential to consider adopting a combination of the above metrics when developing the investment strategy to ensure that the portfolio aligns with the objectives and risk tolerance of the client.
Forecast of Portfolio (5 years)
In this section, we need assumptions regarding the expected returns and risk level to forecast the portfolio returns for the next five years. The client’s current asset allocation is 80% for equity and 20% for fixed income. Assume that the expected return for equities is 6%. In this case, we use the annual compound interest formula to calculate the future value of the retirement account as follows:
Future Value (FV) = PV Value x (1 + Rate) ^ Time
= 100000 x (1 + 0.06/12) ^ (12 x 5)
= $133,823.08 – the future value of the retirement account.
The formula for obtaining the expected returns will be:
Expected Return = (Weight of Investment 1 x Return of Investment 1) + (Weight of Investment 2 x Return of Investment 2) + … + (Weight of Investment n x Return of Investment n)
= (0.5 x 0.078) + (0.25 x 0.07) + (0.25 x 0.04)
= 0.0665
= 6.65%
Calculations for the fixed income are as follows:
Starting value of fixed income portfolio = $100,000
The expected annual return of fixed income portfolio = 4%
Number of years = 5
The formula to use in predicting the future return is:
Future Value = PV x (1 + Rate) ^ Number of years
We can calculate the future value of the fixed-income portfolio after five years as follows:
Future Value = $100,000 x (1 + 0.04) ^5
= $121,665.32
Therefore, the expected value of the fixed-income portfolio after five years is $121,665.32.
Conclusion
In conclusion, the main of the proposed investment strategy is to generate income and maximize returns while minimizing risks for the client. This strategy considers various aspects, such as the client’s goals and objectives and level of risk tolerance. It also has a diversified portfolio that includes cash, fixed income, and equity. The strategy allocates the portfolio to fixed-income securities and calculates expected returns under an assumption of a 3.5 per cent rate. The equity portion’s expected rate of return is 9%.
Moreover, the proposed strategy includes other essential factors, such as derivative strategies, which aim to generate income and manage risks associated with the investment. The strategy also considers the 60/40 rule of taxation. Generally, the above investment strategy aims at providing the client with a diversified portfolio that is also balanced. The client can ensure the portfolio remains on track by doing regular reviews.
References
Bodie, Z., Kane, A., & Marcus, A. J. (2019). Investments. McGraw-Hill Education.
Hull, J. C. (2018). Options, futures, and other derivatives. Pearson Education.
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