Liam is 28 years old and saving toward his retirement in 35 years. In his RRSP h

Question

Liam is 28 years old and saving toward his retirement in 35 years. In his RRSP he owns 1,000 shares of Royal Bank of Canada valued at $98 each and $125,000 principal value of 4.5% Government of Canada 20-year bonds. The bonds trade at a premium of 30%. Liam wishes to sell his investments and purchase a mutual fund.

Part A: What is Liam’s asset allocation? Is it appropriate, and why?

Part B: Risk of Royal bank stock to which Liam's portfolio is exposed to? Risk of GOC bonds that Liam's portfolio is exposed to?

Part C: What type of mutual fund should Liam purchase in order to most closely match his current portfolio? Please explain. Identify one advantage and one disadvantage if Liam swaps his stocks and bonds for a mutual fund.

Explanation / Answer

Part A : Liam's is investing in a combination of bonds and equity. since, he is young only 28 years old, and has a very high risk taking appetite since he is a young investor. he can invest around 70% if his income in equity. asset allocation is not just about investing in stocks and bonds, a comfortable allocation between stocks and bonds is the best strategy to follow. he is investing 44% to equity and 56%to bonds. However as nothing is mentioned about is attitude towards risk weather he is a risk lover or risk averse investor. considering his young age he may increase his allocation to equity .so the current asset allocation is not appropriate.

PART B : the stock that he is holding is exposed to the risk that the share price might fall below $98 and he may suffer a loss due to that.

the risk that the bonds are exposed to is the interest rate risk because of the high duration of the bond. although government bonds are least risky , but the maturity of the bonds is 20 yeras which exposes it to interest rate risk. its a long term bond, in the case of rising interest rate, the prices of the long term bonds will fall the most. the government bond are free from credit risk, that is coupon payments will be made to the bond holder.

Part C : hybrid mutual funds invest in a combination of bonds and equity. the diversification benefits are achieved by investing in a combination of stocks and bonds.

one advantage of mutual funds is the diversification benefits achieved. due to the diversification benefits the risk of invetsing is significantly reduced.

disadvantage is the hidden costs and the fees charge by the mutual funds managers , which might reduce our net return to a great extent.

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