Case 065Client mandates and IPSHard

A wealth firm has three new clients: a 28-year-old engineer, a 50-year-old business owner with a factory loan, and a 70-year-old retiree drawing income. Build three allocations from one set of capital market assumptions and explain what drives the differences.

VanguardMalvern · 2024

The situation

Prayaag Wealth Partners has three new clients. Farhan, 28, a software engineer, has Rs 40 lakh saved and puts away Rs 50,000 a month; his costs are about Rs 60,000 a month. Mrs Deshpande, 50, runs a components factory with lumpy income; she has Rs 12 crore to invest, the business is worth about Rs 10 crore and carries a Rs 3 crore factory loan at 10%. Mr Rao, 70, retired, has Rs 2 crore and needs Rs 1 lakh a month, rising with inflation of about 5%.

The firm's planning assumptions: equity 12% expected return with 18% volatility; high-quality debt 7.5% with 4%; gold 8% with 15%; liquid funds 6.5%. All three clients describe their risk appetite as moderate.

Your task

Build an allocation for each from the same assumptions, and explain which factor moves the equity share the most.

Quick check

All three call themselves moderate risk takers. Who should hold the largest share of equity?

Worked solution

Try it on paper, then open one step at a time.

30-second answerThe answer to give first

Roughly 75% equity for the engineer, 50% for the business owner and 30% for the retiree, and capacity for loss, not stated appetite, drives the difference. The engineer's portfolio is about 23% of his wealth and he keeps saving; the owner's business is already an equity-like bet on the economy; the retiree's Rs 2 crore is all he has and must fund Rs 12 lakh a year. Expected returns run 10.8%, 9.7% and 8.7%.

Step 1If all three say moderate, why do they get different portfolios?

Because appetite is how a fall feels and capacity for lossHow large a fall in the portfolio a client can absorb without their goals or lifestyle changing, judged from their income, other assets, horizon and spending needs. is what a fall does. Two people can dislike rain equally; the one with a car barely notices it, the one walking five kilometres gets soaked. A 30% equity fall costs the engineer about Rs 9 lakh, which his savings replace in 1.5 years; the same fall costs the retiree about Rs 18 lakh, which nothing replaces. Start from the facts that set capacity, then use appetite to fine tune.

Same assumptions, three clients: capacity for loss sets the equity shareEquity 75%Gold 5%Debt 10%Liquid 10%Engineer, 28expects 10.8%, vol 13.6%Horizon: 30+ yearsLiquidity: 6 months of costsCapacity for loss:High: saves Rs 6 lakh a yearEquity 50%Gold 5%Debt 35%Liquid 10%Business owner, 50expects 9.7%, vol 9.3%Horizon: 10 to 15 yearsLiquidity: Business may need cashCapacity for loss:Medium: income tied to economyEquity 30%Gold 5%Debt 47%Liquid 18%Retiree, 70expects 8.7%, vol 6.0%Horizon: 20+ years, drawingLiquidity: Rs 12 lakh a yearCapacity for loss:Low: no income to refill
From one set of assumptions, Farhan the engineer holds 75% equity, Mrs Deshpande the business owner 50% and Mr Rao the retiree 30%, with liquid holdings rising from 10% to 18% as the need to draw on the money grows.
Step 2How much of each client's wealth is the portfolio?

Count what else they own. The engineer's future savings, Rs 6 lakh a year for 32 years growing 6% and discounted at 8%, are worth about Rs 1.35 crore today, so his Rs 40 lakh is only 23% of his wealth. Mrs Deshpande's business, worth about Rs 7 crore net of its loan, rises and falls with the same economy as equities, so her portfolio should hold less equity than her age alone suggests. Mr Rao has nothing else: the portfolio is 100% of his wealth and his only income.

How much of each client's wealth is the portfolio we manage?Engineer, 28future savings, today's value23%equity 75%Business owner, 50business, net of its loan63%equity 50%Retiree, 70100%equity 30%Dark bar: the portfolio's share of total wealth. The larger it is, the less loss the client can absorb.
The engineer's Rs 40 lakh is about 23% of his wealth once future savings are counted, the owner's Rs 12 crore is 63% alongside an equity-like business, and the retiree's Rs 2 crore is all he has, which is why equity falls from 75% to 30%.
Step 3What does each allocation have to solve?
ClientEquity / debt / gold / liquidExpectedVolatilityThe problem it solves
Engineer, 2875 / 10 / 5 / 1010.8%13.6%Growth over 30 years; six months of costs in liquid
Business owner, 5050 / 35 / 5 / 109.7%9.3%A Rs 1.2 crore buffer for the business; less equity because the business is equity
Retiree, 7030 / 47 / 5 / 188.7%6.0%Three years of spending in liquid; enough growth to outlast inflation
The same assumptions give expected returns of 10.8%, 9.7% and 8.7% because each allocation answers a different problem, not a different view of markets.

Two client-specific points make the answer stand out. For Mrs Deshpande, compare the factory loan with the debt fund: prepaying part of a 10% loan earns a certain 10%, more than the 7.5% the debt allocation expects, though the tax treatment of business interest should be confirmed and she may want the loan's flexibility. For Mr Rao, test whether the money lasts: drawing Rs 12 lakh a year rising 5% from Rs 2 crore earning 8.7%, it lasts about 27 years, to about age 97; if equities fall 30% in the first year, it lasts about 22. That 5-year difference is sequence risk, and the 18% in liquid funds exists so he never sells equity in that first bad year.

Step 4What is the limitation?

Every number rests on assumptions that will be wrong in detail: the returns, inflation, the engineer's career, the value of the factory. The allocations are starting points to review every year and after any life event, a job loss, a sale of the business, a health scare. What should survive the review is the logic: capacity for loss first, then liquidity needs, then appetite.

Where candidates lose it

The common loss is building three portfolios from age alone, or from the risk questionnaire alone, and giving all three moderate clients the same 60/40. The interviewer wants to hear capacity for loss named and used.

The second is forgetting the rest of the balance sheet: the engineer's future savings, the owner's business and loan. A portfolio built without them manages the wrong risk.

What the interviewer asks next

  • Farhan wants to buy a flat in three years. How does his allocation change?
  • Mrs Deshpande plans to sell the business in five years. What then?
  • Would you buy an annuity for part of Mr Rao's money, and how much?
  • How would you explain the retiree's sequence risk to his children?

Asked at Vanguard, Investment Research, Malvern, 2024 (Wall Street Oasis): How would you make a portfolio for a variety of different clients with various needs and requirements.

Company names and figures are illustrative.