Total wealth investment advice
Finding the optimal investment portfolio for private individuals
Giving relevant investment advice to private individuals should be based on an understanding of the individuals’ personal financial situation, including current and future assets and liabilities, as well as investment preferences. However, given its complexity, investment advice is often based on the more simplified understanding of risk and return preference of the individual for a defined set of bankable assets (e.g. investment portfolio or cash in the bank account).
In this note, we look at the importance of including non-bankable assets when giving investment advice. Non-bankable assets could be corporate holdings in a family businesses, which might not be easily tradable or real estate. We show that the optimal investment portfolio of a private individual changes substantially when considering non-bankable assets under a defined risk preference. When put into context of the FINANCIAL LIFE GOALS investment process, we increase the understanding of “Your situation” and come to a new optimized personal asset allocation under “Your investment solution” given a stated risk tolerance from “Your preference”. In future notes, we will cover the understanding of liabilities, also considered as financial life goals.
Michael’s investment choice
Let’s take a look at an example. Michael is a 40 years old business man from Basel in Switzerland. Michael has bankable assets with a larger bank with a value of CHF 1.3m. From the risk profiling conducted by his bank, Michael has learned that he is comfortable with an 8% annualized standard deviation of returns. The bank provides 10 optimal portfolios with a set of expected return and risks, from which Michael selects portfolio number 7, as it meets his risk preference (see the tables at the end for the percentage allocations).
Considering Michael’s non-bankable assets
For Michael to only consider his bankable assets when making his investment decision, an important part of the picture is missing. To use an analogy of the corporate world: Simply considering the bankable assets is like checking the cash account of a company and ignoring assets like machines and production facilities. For many people, the non-bankable assets are the larger share of assets compared to the bankable assets.
In addition to his CHF 1.3m investment portfolio, Michael also has real estate with a value of CHF 1m, as well as an ownership in the industrial company where he works valued at CHF 1m.
Michael’s total wealth = Investment portfolio + real estate + company ownership
Many people regard real estate investments as a safe investment. However, history shows that real estate can correct substantially in price and is often highly correlated with equity markets. Michael’s total investment risk that includes both his investment portfolio, real estate and company investment therefore significantly exceeds his preference for an 8% standard deviation of returns.
Michael’s optimal investment choice
Michael’s optimal portfolio choices given his fixed allocation to real estate and company investment as well as his risk preference is displayed below. To stay with a risk preference of 8% standard deviation of returns on his total wealth, Michael selects portfolio 2 (see the tables at the end for the percentage allocations).
If we single out the liquid investment portfolio, the optimal portfolios look quite different:
The most striking difference is that Michael should hold a much larger share in government bonds when non-bankable assets are considered: the allocation to government bonds jumps from 17% to 73% in his investment portfolio. This is in order to balance the higher risk coming from the non-bankable assets and to increase the degree of diversification of the total wealth.
Why is investment advice often simplified?
There can be many reasons for why non-bankable assets are not considered when giving investment advice. Some private individuals might not be willing to share their total wealth information, and often the investment advisor will not have the right tools to solve the portfolio optimization problem.
New and upcoming financial regulation such as MiFid II and Fidleg require financial advisors to collect information for a wider understanding of a client’s asset and liability situation, the investment purpose and investment horizon. We therefore believe there is a real opportunity for investment advisors to provide better and more relevant advice going forward.
How to give total wealth investment advice
In order to give investment advice based on a full set of assets, the investment advisor needs to be able in a systematic way to collect information on the individual and keep it updated. In addition, an investment application is needed that allows for:
- Capital market assumptions for all asset classes, including the less liquid non-bankable parts such as real estate and company investments
- A portfolio optimization routine that can find the optimal investment portfolio given the preferences and constraints of the investor
Conclusion
Including non-bankable assets of private individuals into the investment advice should help individuals avoid unpleasant surprises in bad times and give a better understanding of the total wealth situation and risks involved. The advantages of giving total wealth investment advice can be summarized to the following:
- Giving the private investor an overview of his or her financial situation
- Keeping the investor’s total investment risk within the stated preference
- Not being over-exposed to a certain asset class or risk factors
- Ensuring that the investment portfolio is optimized for all assets
FINANCIAL LIFE GOALS investment API
The above calculations were carried out using the FINANCIAL LIFE GOALS investment API and can be made available either as a stand-alone application, or integrated into existing tools or applications.
This article was written jointly by Mark Andersen, Bernhard Obenhuber and Nicolas Camenzind. We will be excited to hear your thoughts on our series of investment notes. Contact us anytime via contact@financial-life-goals.com or have a look at our website at www.financial-life-goals.com
Appendix
Note: The source for all the investment calculations are SWISS FIN LAB, using capital market assumptions from JP Morgan Asset Management.
For this publication, we assume that Michael’s real estate has similar characteristics as the European direct real estate index. For Michael’s holding of a mid-sized industrial company, we have taken the characteristics of a private equity investment as a proxy. An alternative would have been to use listed small cap equity indices for the specific sector.
