section 1 - The American College Online Learning Center

2 $4,900 –20% $3,920 $1,100 $2,8203 $2,820 0% $2,820 $1,100 $1,7204 $1,720 –20% $1,376 $1,100 $ 2765 $ 276 –40% $ 166 $1,100 $ (934)f. Planning Point: With market risk, the most fundamental piece of investmentadvice—diversification—does not work, if by diversification one means investingin different risky assets.g. Planning Point: Market risk is avoided by holding nonrisky assets such as CDsand savings bonds. However, these investments typically provide the lowest ratesof return available in the market place.h. Planning Point: Too often, clients who suffer market setbacks pull out of equitiesto create a “buy high, sell low” scenario. Research has shown that the actual ratesof return achieved by mutual funds are typically higher than the rates of returnachieved by investors in those mutual funds. This is because many individuals,left to their own investment timing, will base their investment decisions on recentmarket movements. Thus, when stock prices have been going up, they buy, andwhen stock prices are going down, they sell. So although everyone knows thatthe simple way to make money in investments is to buy low and sell high, manyinvestors will regularly end up buying high and selling low.3. Reinvestment risk is the chance that as higher-yielding fixed income investments mature,the client may need to reinvest that principal and possibly interest payments into alower-yield fixed income investment. Your clients should be concerned about beingunable to duplicate yield on fixed investments for a variety of reasons:a. Retirees often rely on returns from fixed income investments and may not be ableto acquire the needed rate of return when they must lock in the investment.b. Example: Arthur’s investments include a substantial portion in bonds of variousmaturities. As principle and interest payments come due, some of the cash iswithdrawn to cover expenses, and the rest is reinvested into new bonds. Arthurhears that interest rates have been falling, and is pleased to note that the valueof his bond portfolio has risen from $400,000 to $425,000. However, Arthur alsonotes that when he goes to reinvest his principal and interest payments, he isno longer able to find bonds with yields comparable to what he had previouslybeen getting. He realizes that because of the lower interest payments on the newbonds, his interest income from the portfolio is falling, and he will have to liquidatemore bonds than he anticipated to meet his needed withdrawals.c. Planning Point: Zero coupon bonds, since they do not make coupon interestpayments, eliminate the reinvestment risk associated with the coupon payments.An example of a zero coupon security is U.S. Treasury strips.4. Liquidity risk is the inability to have assets available to financially support unanticipatedcash flow needs. Clients should be concerned about being able to access fundsa. Example: Fengyum’s portfolio consists solely of single premium annuities andinvestments in extended maturity certificates of deposit. When a sudden accidentforces her to remodel her house for one floor living, she is unable to obtain thecash necessary to complete the project because of the restrictions on liquidatingthe annuities and penalties on early withdrawals from the certificates.b. Example: Russ owns undeveloped real estate when he is confronted with theneed to support his daughter who is out of work because of a recession caused by5.23