Situational profiling an investor by stage of life

Situational profiling an investor by stage of life

In life stage classifications, investment policy and particularly risk tolerance are determined by one’s progress on the journey from childhood to youth and adulthood, maturity, retirement and death. A person’s ability to accept risk should begin at a high level and gradually decline through his lifetime, while willingness to assume risk should be driven largely by cash flow considerations. An individual’s investment policy can be viewed as passing through four general phases:

o   Foundation

o   Accumulation

o   Maintenance

o   Distribution

Foundation

The individual is establishing the base from which wealth will be created (marketable skill, establishment of business, acquisition of educational degree). During this phase, the individual is usually young, with a long time horizon, which normally would be associated with an above average tolerance for risk. Risk tolerance should certainly be above average in the foundation stage if the individual has inherited wealth. Lacking such wealth, the foundation phase may be the period when an individual’s investable assets are at their lowest and financial uncertainty is at its highest.

Accumulation Phase

Earnings accelerate as returns accrue from the marketable skills and abilities during the foundation period and gradually reach their peak. In the early years of the accumulation phase, income rises and investable assets begin to accumulate. Income generally continues to rise as the individual reaches peak productivity. If individual personal spending habits do not change, the gap between income and expenses may widen throughout the accumulation phase, allowing for an increase in savings. This phase is characterized by increased risk tolerance, driven by their increasing wealth and a still long term horizon.

Maintenance Phase

The individual has moved into the later years of life and usually has retired from daily employment or the pressures of owning a business. This phase focuses on maintaining the desired lifestyle and financial security. Preserving accumulated wealth begins to increase in importance, while the growth of wealth may begin to decline in importance. Risk tolerance will begin to decline, not only is the individual’s time horizon shortening but his confidence in the ability to replace capital or recover from losses is often diminished. In this stage investors typically reduce exposure to higher volatility asset classes and increase exposure to lower volatility investments.

Distribution phase

Accumulated wealth is transferred to other persons or entities. This phase begins when the individual is still reaping the benefits of the maintenance phase and retirement. Tax constraints becomes important as investors seek to maximize the after tax value of assets transferred to others. Although asset distribution may take place in the later stages of life, planning for such transfers can begin much earlier.

Although the progression from accumulation to distribution may be linear, it is not necessarily so. Individuals in the accumulation phase may become dissatisfied with a career choice and return to the foundation phase. Situational assessments allow investment advisors to quickly categorize potential clients and explore investment issues likely to be of greatest importance to them. Dynamic relationship exists among the above considerations. The value of situational paradigms therefore lies more in their general insights into human behavior and less in their ability to fully interpret individual circumstances. Investment advisors should emphasize the process of gathering and assessing relevant situational information rather than the specific category in which an individual investor may fall.