section 1 - The American College Online Learning Center

a collapse in the real estate market. Russ suffers from liquidity risk because hisundeveloped land cannot be sold for a fair price. Liquidity gives clients the greatestdegree of flexibility to adapt to their changing world. This financial independenceempowers them to shift their priorities and exercise control over their environment.c. Planning Point: An emergency fund can meet the client’s need for short-termliquidity without forcing the sale of illiquid assets to meet the needs of the financialemergency.LO 5-3-2: Evaluate the solutions a planner can use to help his clientaddress the risks associated with depending on investments in retirement(investment risk, asset allocation risk, market risk, sequence of returnsrisk, reinvestment risk, and liquidity risk)1. Use a laddered bond portfolio.a. Within an investment portfolio, it is possible to structure the bond holdings toenhance the ability of the portfolio to support the client. A bond ladder is one inwhich the portfolio is invested in bonds whose maturities are spread evenly acrossa selected time horizon.b. Example: A simple bond ladder would be a 10-year ladder, which would have 10percent of the portfolio mature each year. Suppose Tex has a $1,000,000 portfolio,and puts 60 percent into equities and 40 percent into bonds. The $600,000 inequities could be invested in several equity mutual funds that cover a varietyof objectives. The $400,000 in bonds could be invested across a 20-year timehorizon, wherein $20,000 is set to mature each year. Thus, regardless of whateverelse happens in the market, Tex knows he has $20,000 coming in each year.c. Bond ladders solve the investment risk problem in most cases becausegovernment and highly rated (e.g., AAA) bonds seldom default.d. Bonds may not help with reinvestment risk if they are coupon bonds and youare planning to reinvest the coupons.e. A bond ladder with government bonds will help with liquidity risk.f. A bond ladder that holds bonds that are thinly traded will be hurt with liquidity risk.2. Use an immunization strategy.a. An immunization strategy is a more sophisticated version of a bond ladder. Animmunization strategy is one wherein after selecting a time horizon, the clientbuys bonds whose duration statistic is approximately equal to the desired holdingperiod. By buying a bond whose duration statistic matches a desired holdingperiod, the client trades off price risk with reinvestment rate risk. A bond ladderonly assures that the par value is available at particular times in the future. It saysnothing about what the value of the reinvested coupons will be. The goal of animmunization strategy is that when the holding period is over, any gain or loss inthe price of the bonds will be offset exactly by a loss or gain in the value of thereinvested coupon payments, such that the client will receive the yield to maturitythat existed on the bond at the time of purchase.b. Example 1: A 4 percent coupon bond with a 10-year maturity and a yield tomaturity of 8 percent will have a duration statistic of 8.12 years. This means that ifone buys this bond today, and sells it in 8 years (2 years prior to maturity), thenone is more likely to attain a yield of 8 percent on this investment than if onehad simply bought a bond that matured in 8 years. The reason is that using thematurity does not incorporate the impact of interest rate changes on the reinvestedcoupons over the holding period.5.24