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(1) What additional information would Henry Li require in order for him to give a sound investment advice to Ester Tong?
Below are some areas where additional information should be gathered from.
Required return ratio and risk tolerance
Though it is Henry Li, as an investment analyst’s job to reduce the overall risk of the investment portfolio, still he should collect necessary information about the required return ratio and the risk tolerance of his client, Ester Tong. As portfolio investments are not risk-free, and what is more, some are more risky than others. And also investors could only be rational in the models. That’s why as suggested by Susan M. Drake (2009) only the clients could decide how comfortable they feel with a high or a low risk investment, and in general higher risk indicates higher potential return or payback the investors will eventually get while lower risk indicates lower potential return or payback even after the ultimate efforts to eliminate the non-systematic risks by applying the portfolio investment theories. As mentioned in the case, Ester Tong has been investing the stock portfolio for the future college tuition usage purpose and also she will be using this tuition next year. From this description we can assume that the client has a low risk tolerance and a low required return ratio in the coming year. But still Henry Li should have a long talk with the client and let the client make the final decision about the tolerance for risk.
A client profile summarized the basic information that the client provides based on which the investment analyst could construct the investment plan and provide the investment advices (Elmiger & Kim 2003, p. 209). Several items in the client personal profile should attract the investment analyst’s attentions when it comes to the key decision making. The first information is the birthday and retirement age of the client which could affect the purpose of the investment which further affects the risk tolerance and required return ratio in the given period of time. The second type of information is the salary of the client which strongly affects risk tolerance of the client because most individual clients will account on their salary to recover the lost if there should be any during the investment activities.
Taxes considerations and regulation impacts
Because what does matter is the post-tax return from any investment, tax considerations therefore have an important bearing on investment decisions (Chandra 2008, p. 592). As mentioned in the case, tax considerations are also important factors influencing the final decision made by Henry Li if applicable. So it is also necessary for Henry Li to review the tax policy such as the tax shelters available when making investment decisions. And in term of regulation considerations, though in most cases individual investors are not constrained much by law, it is better to understand some policy directions that the government makes in a certain period of time or some special regulations in the particular funds such as the regulations on the mutual funds.
One of the most important elements in the markets in the cost of trading though it is not mentioned in many theoretical models because different markets will have different rate of trading cost level, and the size of the trading costs affects how large the perceived mispricing must be before an investor could profitably swap one share for the other (Elton, Gruber, Brown & Goetzmann 2010, p. 39). As said in the case, what Henry Li recommended to Ester Tong is that one new stock be added to the portfolio by selling ether 10% or 20% of the portfolio’s value and do the reinvestment in the particular recommended stock, this means that around RM 2,500 to RM 5,000 value stock portfolio will be changed to other stocks. And the incurred due to the change of stocks need to be taken into consideration as an important trading cost.
Income or dividends usually would come in time by time or periodically, and it is useful to take into account the income brought by the investment activities in a time perspective in term of net present value which refers to the excess of present value of future cash inflows over the above the cost of the original investment (Ramachandra 2006). And also the net present value is considered as the best single criterion in selecting stock portfolio primarily because it is directly related to the firm’s central goal of maximizing the stock’s intrinsic value (Brigham & Ehrhardt 2011, p. 383). As mentioned in the case, the portfolio investment of the client will about to last only for another year because the client is going to use it to pay the tuition for education purpose. It will be important to take into account this time limit and make the benefit maximization within the said time frame.
(3) Evaluate Henry Li’s intention to advice to Ester to add a new stock by selling a certain percentage of her current holding. Would this reduce her risk and improve the returns on her portfolio?
Assume that the client would like to reduce the risk and earn enough of return and then leave the market because she is going to use the fund for education purpose. Two kinds of measurement should be done to evaluate the decision made by Henry Li’s to advise Ester to add a new stock by selling a certain percentage of her current holding: assessment on the stocks to be sold out to the market and assessment on the stocks to be bought in to replace the original share. Firstly, it could be a bad decision the change the portfolio if the stocks to be sold are stock from the mature company from which the company could earn enough and just leave the market. And it should be suitable if Henry Li advises the sell the stocks that is currently losing or those stocks that are not good for the portfolio. Secondly, it could be a bad idea to replace part of the portfolio with those stocks that only bring in incomes in a longer period than the allowed time frame which is one year in this case.
By introducing other new stocks into the portfolio that are not positively relative to the remaining stocks, according to what we had discussed above, it will be expected to reduce the overall portfolio risks through the elimination of the non-systematic risk by diversifying the investment portfolio. But in term of whether this change will finally lead to the increase return of the investment, more investment analysis and date collection will be needed to come to a final result.
Brigham, E. F. & Ehrhardt, M. C. 2011, Financial Management Theory and Practice. Mason: South – Western Cengage Learning. p. 383
Chandra, 2008, Investment analysis & portfolio management. New Delhi: Tata McGraw – Hill. p. 592
Drake, S. M. 2009. Freelancing For Dummies. Hoboken, NJ: Wiley Publishing, Inc.
Elton, E. J., Gruber, M. J., Brown, S. J. & Goetzmann, W. N. 2010, Modern Portfolio Theory and Investment Analysis. New Jersey: John Wiley & Sons, Inc. p. 39
Efficientfrontier.com 2000. The 15-Stock Diversification Myth [online] available: http://www.efficientfrontier.com/ef/900/15st.htm
Krantz, M. 2008. Investing Online For Dummies. Hoboken, NJ: Wiley Publishing Inc.
Elmiger, G. & Kim, S. S. 2003, Risk grade your investments: measure your risk and create wealth. New Jersey: John Wiley & Sons, Inc. p. 209
Lee, C. F. & Lee, A. C. 2010 Handbook of Quantitative Finance and Risk Management. New York: Springer
Markowitz, H. 1952. Portfolio Selection. Journal of Finance 7, no. 1 (March 1952): 77- 91; and Harry Markowitz (1959), Portfolio Selection – Efficient Diversification of Investments New York: John Wiley & Sons.
Ramachandra 2006. Econ., Acc., and Man for Jntu. New Delhi: Tata McGraw – Hill Publishing Company Limited.