SIE Chapter 8
Freeriding
A cash account is an account where the transactions are paid for with cash, or cash equivalents, within a specified time. Regulation T requires payment no later than 4 business days after the trade date or T+4. Investors must pay for their purchases of securities before selling them. If a customer attempts to profit on and then sell those same securities before paying for them, it is called _______ and is prohibited under Regulation T. The broker-dealer will freeze the cash account for 90 days for this violation. During this time, the client must fully pay for all purchases with cash up front (CUF) on the date of trade.
Legislative Risk
A change in the law can have a major impact on a company's business prospects.
manipulative practices
The Securities Exchange Act of 1934 addressed manipulative practices involved in the securities industry through adding specific provisions that deal with deceptive behavior. The Act of 1934 specifically states: "It shall be unlawful for any person, directly or indirectly, by the use of any means or instrumentality of interstate commerce, or the mails or any facility of any national securities exchange to: Employ any device, scheme, or artifice to defraud Make any untrue statement of material fact or omit to state a material fact necessary in order to make the statements made, in light of the circumstances under which they were made, not misleading Engage in any act, practice, or course of business which operates or would operate as a fraud or deceit upon any person in connection with the purchase or sale of any security."
Regulation M
The Securities Exchange Act of 1934 contains Regulation M rules 100-105. These rules were established to control the activities of syndicate members and market makers that are participants in follow-on offerings. The concern is that these firms will attempt to manipulate the price of the security by buying or selling the subject security in the secondary market prior to the effective date of the follow-on offering. This caused damage in the time period following the effective date when the security price dropped to its normal trading price and buyers of the follow-on offering were subject to large losses on that holding. Regulation M prohibits the syndicate members in a follow-on offering from aggressively trading the subject security in the secondary market and has placed time restrictions on thinly traded securities to only allow trading after the effective date. The regulation also curtailed aggressive short sales in these securities that would drive the price down before the effective date by only allowing these traders to cover their short positions at the offering price established in the days following the effective date.
Market Manipulation
The Securities Exchange Act of 1934 prohibits all persons from participating in any form of market manipulation. Market manipulation is the deliberate attempt to interfere with market operations by creating artificial or misleading appearances regarding the price or trading activity of a security. The use of manipulative trading practices is unethical and generally considered fraudulent. The only permissible form of market manipulation is stabilization.
Civil Penalties
The civil penalty for insider trading is the greater of 300% of the profit gained or the loss avoided, often referred to as treble damages, from the illegal trading or $1 million. The SEC also offers bounties, or rewards, to individuals who provide information concerning insider trading. These individuals are known as "whistleblowers," and they are paid out of monies recovered as penalties under the act. The maximum amount payable to whistleblowers is 10% of the penalty imposed upon the insider.
Fair Dealing with Customers
The fundamental responsibility for fair dealing with customers is implicit in all member and registered representative relationships. Sales efforts must only be made based on the ethical standards of FINRA's Conduct Rules. FINRA has taken disciplinary action and imposed penalties in many situations where members' sales efforts have exceeded the reasonable grounds of fair dealing. Practices that have resulted in disciplinary action and clearly violate this responsibility for fair dealing include the following: Recommending speculative low-priced securities, Excessive trading activity, & Trading in mutual fund shares
Backing Away
Under SEC Rules, all quotes made by market makers must be firm. The market maker must honor the size and price of the quote that they have displayed. Backing away, which occurs when a firm fails to honor their quote, is prohibited and may result in a monetary fine, suspension from market-making, or both.
Time Horizon
A customer's projected holding period may dramatically alter their investment strategy. Determining an investor's risk tolerance requires knowledge of the investor's time horizon. An investor who has a short-term time horizon, such as an investor approaching retirement, might not want to risk losing investment income due to market volatility. This investor would have a low risk tolerance and would need to invest conservatively. A young investor with a long-term horizon and many years of earning ahead can usually tolerate the fluctuations of the market and invest more aggressively. Additionally, an investor's attitude toward market volatility can determine their time horizon and risk tolerance. An investor who can invest and hold onto a security for a long period of time, without the pressure to sell it, will usually overcome any short-term volatility in the market.
Customer Balance Sheet
A personal balance sheet, or financial ledger, should be constructed for a new customer. All of the customer's assets are listed on the left side, and the customer's liabilities, are listed on the right side. The difference between the two is the customer's net worth.
Recommending Purchases Beyond a Customer's Capability
A registered representative cannot recommend the purchase of securities or the continuing purchase of securities in amounts which are inconsistent with the reasonable expectation that the customer has the financial ability to meet such a commitment.
Pump and Dump
Another form of market manipulation that involves market rumors is the ____. An individual or group that owns a security will use market rumors to promote a stock on the internet, attempting to drive the price up. These stocks tend to be small or micro-cap stocks that are thinly traded. Prior to the release of the market rumors, those involved in the scheme will buy large quantities of the stock at very low prices. Releasing the market rumors will "pump" up the price of the stock. The violators will then sell or "dump" their largely appreciated holding at a large profit.
Misuse of Customers' Funds or Securities
Any unauthorized use of an account, or borrowing of customers' funds or securities is considered misuse. This is generally regarded as theft of customer funds. In addition, member firms are prohibited from commingling (mixing together) assets owned by customers with assets owned by the member.
Unauthorized Transactions
Causing the execution of transactions that are unauthorized by customers, including executing discretionary transactions without written discretionary authority, or the sending of confirmations in order to cause customers to accept transactions not actually agreed upon.
Value line Index
Covers 1,700 stocks that are listed on NYSE, AMEX, and NASDAQ
Omissions of Material Facts
Deliberately withholding a material fact from a client is a fraudulent act. While it may not be practical or possible to disclose all known facts regarding an investment to a client, the RR must determine what information is material and relay that information to the client. The following are examples of information that would be considered material facts: Acquisition or buyout of an issuer, Industry changes, Changes in management of an issuer, Changes in competition, Risks associated with a particular investment, Changes in tax laws that may affect an investment, & New or proposed government regulations
Participation in Employer-Sponsored Benefit Plans
Does a client have a retirement plan available from their employer? Is it a pension or a plan that the employee may contribute to on a pretax basis? In many cases, the tax benefits of investing in an employer-sponsored plan make it the most attractive option. Another often overlooked benefit is the ability to purchase group life, health, dental, disability, and long-term care insurance at a discounted rate through an employer.
Insurance Needs
Does the client have adequate life, health, homeowners, and automobile insurance? This information should be obtained prior to engaging in an investment program. Although saving and investing are important, an appropriate amount of insurance is a necessary expenditure, especially for clients with young children.
Fictitious Accounts
Establishment of fictitious accounts in order to execute transactions that otherwise would be prohibited, such as the purchase of new issues by prohibited persons, or to disguise transactions that are against firm policy.
Excessive Trading Activity (Churning/Twisting)
Excessive trading activity in a customer's account is often referred to as churning, twisting, or overtrading. There are no specific standards to measure excessive activity in customer accounts because this must be related to the objectives and financial situation of the customer involved.
Currency (Exchange) Risk
Exchange risk is encountered by investors in foreign securities. The risk occurs as the value of foreign currencies fluctuate against the U.S. dollar. Investors in overseas or international mutual funds will encounter this additional risk.
Fair Dealing with Customers with Regard to New Financial Products
FINRA emphasizes members' obligations for fair dealing with customers when making recommendations or accepting orders for new financial products. As new products are introduced from time to time, it is important that members make every effort to familiarize themselves with each customer's financial situation, trading experience, and ability to meet the risks involved with such products and to make every effort to make customers aware of the pertinent information regarding the products.
FINRA Suitability Standard Rule 2111
FINRA requires RRs to perform due diligence in determining the suitability of investment vehicles (including mutual funds) and strategies they recommend to a client. The 3 main suitability obligations include: Reasonable Basis Suitability, Customer Specific Suitability, & Quantitative Suitability. To make recommendations regarding transactions or investment strategy, a registered representative may complete a personal balance sheet to help the customer determine whether they have the financial ability to implement the recommendations.
Anti-intimidation and Coordination
FINRA's regulations promote fair and just principals of trade for any member firm and their associated person. It is therefore, considered a violation to intimidate other members by threats or harassment in an attempt to influence items such as pricing, quoting, or research reports. Retaliating against another member or associate is also not allowed in regard to the same items. It would also be a violation to coordinate prices, trades, or reports with any other member or associated person. Paying any party in an attempt to influence the market price of a security is also prohibited.
Trading Ahead of Research
Firms are not allowed to trade in their own accounts based on information that is received from their own underwriting and/or research departments prior to the release of a research report.
Financial Exploitation of Seniors
Firms are now required to make reasonable efforts to obtain the contact information of a trusted contact person for a customer's account. Financial abuse can take many forms, and senior citizens are often seen as easy prey. Firms need to be alert for investment scams, forgery, intimidation, retitling accounts, and theft. FINRA allows firms to place temporary holds of up to 15 days on accounts where fraud is suspected; that hold may be extended an additional 10 days if the firm believes the customer is being financially exploited. During the time when the hold is in place, the firm will document the reason for the hold and must notify the trusted contact person. Member firms will also reach out to the trusted contact person if they suspect the customer is experiencing diminished mental capacity or to obtain the identity of the legal guardian, trustee, or power of attorney for the customer.
Quantitative Suitability
Firms must have a reasonable basis to believe the number or size of recommended transactions within a certain period is not excessive, in light of the size and character of the customer's account.
Reasonable Basis Suitability
Firms must have a reasonable basis to believe, based on adequate due diligence, that a recommendation is suitable at least for some investors.
Customer Specific Suitability
Firms must have reasonable grounds to believe a recommendation is suitable for the specific investor based on the customer's profile.
Marital Status
Generally, a single individual is more aggressive than a married couple. Two parent families have different needs than single parent families. If married, does the household have double income? If divorced, a client may have a decrease in income or financial situations may exist, such as paying or receiving alimony and/or child support. If the client is a widow/widower, additional needs may arise. An older widow may have limited assets available to meet financial needs for the balance of their lifetime, whereas a younger widow may be concerned about living on one income and raising children alone for a long time.
Sharing in Accounts
Generally, no member firm or associated person can share directly or indirectly in the profits or losses in any account of a customer carried by the member firm or any other member. However, a member firm or associated person CAN share in the profits or losses in such an account if: The member firm or associated person obtains prior written authorization from the customer, The associated person obtains prior written authorization from the member firm & The member firm or associated person shares in the profits or losses only in direct proportion to the financial contributions made to the account. An exemption is also made if an associated person opens a joint account with an immediate family member of the member, including parents, mother-in-law or father-in-law, spouse, children or any relative to whose support the associated person contributes, either directly or indirectly. If an associated person opens up a joint account with a client, regardless of whether it is a family member, the following must occur: The client must agree to the account in writing, The account must be approved by a principal, &The associated person and the customer must share in profits and losses in proportion to their contributions
Borrowing from or Lending to Customers
Generally, registered representatives are prohibited from borrowing from or lending to their customers. However, the following conditions allow for instances when borrowing from or lending to customers is permissible: The member firm must have written procedures allowing the borrowing and lending of money between registered persons and customers The lending or borrowing arrangement meets one of the following conditions: □ The customer is a member of the registered person's immediate family □ The customer is a financial institution regularly engaged in the business of providing credit, financing, or loans, or other entity or person that regularly arranges or extends credit in the ordinary course of business □ The customer and the registered person are both registered persons of the same member firm. □ The lending arrangement is based on a personal relationship with the customer, such that the loan would not have been solicited, offered, or given had the customer and the associated person not maintained a relationship outside of the broker-customer relationship □ The lending arrangement is based on a business relationship outside of the brokercustomer relationship. The registered person must notify their firm before proceeding with any of these arrangements and the firm must give written approval prior to the loan occurring. The approval must be held for 3 years beyond the termination of the loan arrangements or termination of the registered person's employment.
Most Common Indexes
Here are some of the most common indexes and how they are constructed: Dow Jones :Industrial 30 large-cap chosen to reflect U.S. Economy Mostly NYSE Standard and Poor's 500: 500 largest capitalization companies Value Line: 1,700 companies NYSE, AMEX and NASDAQ Wilshire Index: Broadest Index - Total market Originally 5,000; now 7,000 NYSE, AMEX and NASDAQ Russell 2000: 2,000 small-cap stocks Mainly NASDAQ and NASDAQ OTC
Income
How much does the client earn? Is the income stable, or does it fluctuate based on commission? Does the client receive a year-end bonus? Is the income expected to change in the short run? How will the income change in the long run?
Dependents
If the customer has children, it is important to know their ages. Couples with young children may have a need to save for college education. The customer may have a child with special needs that requires special needs planning.
Attitudes Toward Risk
In any investment there is a risk, whether large or small, that an investor might lose some or all invested money. A registered representative must know how a client perceives risk. In theory, the greater the risk, the more return the investor should receive for holding the investment. An investor with a high-risk tolerance is more likely to be an aggressive investor. The expectation of a higher return compensates for bearing more risk. Likewise, an investor with a lower risk tolerance should expect a lesser return.
Customer Recommendation Requirements
In recommending to a customer the purchase, sale, or exchange of any security, a member firm must have reasonable grounds for believing that the recommendation is suitable for that customer and must make a reasonable effort to obtain the following information on the customer: List of other securities holdings the customer owns, Financial situation, Investor's current needs, Investor's long-term needs, Age, Tax status, Liquidity, Time horizon, Investment objectives, Risk tolerance, Marital status, Occupation, Other information used or considered to be reasonable in making recommendations to the customer
Risk-adjusted Return
In the securities industry, the greater the risk taken, the greater the reward received over time. Conversely, the less risk taken, the less reward received over time. Every security carries certain inherent risks. This risk relationship is measured by the risk-adjusted return. The risk-adjusted return measures the security's return based on the amount of risk.
Criminal Penalties
Individual (natural person) - Maximum fine is $5 million. Non-natural Person (corporation, partnership, association) - Maximum fine is $25 million. Prison - Maximum term for one offense is 20 years; corporate officers can be subject to imprisonment for the unlawful acts of the corporation committed with their knowledge or assent. Contemporaneous traders are individuals who, without benefit of the non-public information, enter a trade at about the same time as the insider. Persons who engage in insider trading are also subject to private civil action initiated by contemporaneous traders for their actual losses or lost profits.
Inflation (Purchasing-Power) Risk
Inflation (rising prices) means money will buy less in the future than it does now. Fixed-income investors are the most vulnerable to purchasing-power risk while equity investors may be afforded some protection due to the potential appreciation of their holdings.
Risk Management Strategies
Investors are often willing to take on more risk for the possibility of greater rewards. Taking on less risk could greatly reduce an investors potential return. There is always a trade-off between risk and reward. There are also strategies that investors and portfolio managers use to help reduce risks while maintaining the potential for greater rewards.
Asset Allocation
Investors may also want to consider the proper _____ for their risk tolerance. More conservative investors may have a higher concentration of bonds in their portfolios; an aggressive investor may have very little bond exposure in their portfolio. There are many asset classes to choose from, and each carry their own level of risk. There are stocks, bonds, and money market securities, and several sub-divisions of each of those. Money market securities or funds are considered one of the lowest-risk investments, but do not keep pace with inflation and should never be the only asset in a portfolio.
Participation in Retirement Programs
Is the client contributing to an IRA or Roth IRA? If self-employed, is the client taking advantage of small employer retirement plans?
Employment Status
Is the client just beginning, at the peak of their career, or getting ready to retire? How many years does the client have left to work? If self-employed, the client may also have business succession needs.
Estate Planning
Is the customer investing for themselves or future generations? Many older customers are financially secure and are making investments with the expectation they will be passed on to their children or grandchildren. The older investor may take on the investing profile of the expected beneficiary. Gifting considerations, such as contributions to charities, should also be addressed.
Benchmarks
It is important to understand the major indexes because portfolio managers use them to measure performance. The goal of most of them is to match or beat the return of their benchmark index. The benchmark must be comparable to the portfolio. A small-cap growth fund would want to benchmark a small-cap index such as the Russell 2000. The portfolio manager couldn't choose the S&P 500, which is all large-cap stock, as their benchmark. In an effort to evaluate portfolio managers, comparisons are often made between the return of the index and the actual return of the portfolio. The amount of return that is above the return of the index is called the Active Return. The return of the index is called the Passive Return.
Relevant Personal and Financial Information
It is necessary to have both personal and financial information about a client when constructing a customer profile. The following information must be taken into consideration: Age, Marital Status, Dependents, Employment Status, Income, Expenses, Disposable income, Discretionary income, Assets and Liabilities, & Liquid Assets (Cash Reserves)
Misleading Statements
It is prohibited to make misleading or untrue statements, such as exaggerating the performance or inaccurately stating the issuer's earnings or projected earnings of a security, to induce someone to engage in a securities transaction. It can be misleading to use the term "Guaranteed". Guaranteed is defined as "guaranteed as to payment of principal, interest, or dividends." Guaranteeing a profit, or no loss, regarding the performance of a security is considered misleading and prohibited.
Tax Status
Knowing the customer's filing status and any expected changes is beneficial, as well as the customer's tax bracket, or marginal rate of taxation. Some customers in higher brackets may consider investments in municipal (tax-free) bonds or various tax-deferred (pay tax later) investments. Key Concept: The marginal rate of taxation is the amount paid on the last dollar earned. A customer in the 30% bracket would pay $30 dollars of tax on the last $100 of income. ($100 x .30 = $30)
Prohibition Against Guarantees
No member firm or associated person can guarantee a customer against loss in connection with any securities transaction or in any securities account.
Fraudulent Account Activity
Numerous instances of fraudulent conduct have been acted upon by FINRA and have resulted in penalties against members. Among some of these activities are: Fictitious Accounts, Unauthorized Transactions , & Misuse of Customers' Funds or Securities
Signature of Convenience
Registered representatives are strictly prohibited from using a "signature of convenience" by asking a customer to sign a blank form to keep on file for use later. It is unlawful for any person to knowingly alter any document or forge the customer's signature. Customers must receive copies of everything they sign. Withholding or falsifying documents is prohibited. All forms and other records must be kept in accordance with FINRA rules. Improper maintenance and retention of records can lead to disciplinary action.
Creating a Customer Profile
Registered representatives should attempt to gather as much information as possible during their early discussions with a potential client. This information helps to develop a customer profile and gain a greater understanding of the client's financial situation and attitudes prior to making any recommendations. No investment is inherently suitable or unsuitable for all investors in all situations because suitability depends on each investor's unique situation and circumstances. Through interviews and the use of questionnaires, adequate customer background information can be collected to help make a suitable investment recommendation. The RR must make a reasonable effort to obtain the customer's financial information, including their assets, income, expenses, and tax situation, as well as prior investment experience, attitudes towards risk, and investment objectives.
Selling Dividends
Selling dividends is a prohibited practice that occurs when an RR recommends a purchase of shares just before the ex-dividend date. By purchasing shares before the ex-date, the customer will receive a dividend that is immediately taxable—so this practice is considered to be "selling a taxable event." By waiting until after the ex-date, the share price will reduce by the amount of the dividend payout, which means the customer will have more money invested in the fund without the tax liability right away.
When the economy is expanding....
Small cap stocks outperform large cap stocks
False Transaction Reports
Some manipulative schemes are so bold as to dispense with real trades altogether. Instead, the perpetrators distribute false reports of transactions, a less expensive, but still illegal, method of manipulation.
More on prohibited practices
Specific activities have been named and defined as illegal through these laws. These rules apply to all persons and securities, not just those registered with the SEC, FINRA, states, or other regulatory authorities. Market manipulation is illegal and is punishable at both civil and criminal levels depending upon the offense and if the behavior was intentional. Intentional violations of the law are considered fraudulent and usually punishable at the criminal level. Unintentional violations are usually punishable at the civil level. Criminal penalties are higher than civil penalties.
Inflation
The impact of inflation on an investor's portfolio depends on the types of securities that they hold. If they invest in stocks, a stable company's revenue and earnings should increase over time at or greater than the pace of inflation. In the long term, stocks have been shown to be protection against inflation. Fixed-income investors are the hardest hit by inflation, as their rates of return are more likely to be less than inflationary increases. Key Concept: Bonds investments do not protect a customer against inflation. Equity holdings may preserve a customer's purchasing power.
Tipping Insider Information
The person passing on the information, called the tipper, and any person that trades on that information, the tippee, are both liable. There is no violation for either party if no trades were placed based on the information. Federal insider trading regulations mandate broker-dealers establish and maintain safeguards to prevent the misuse of inside information. A registered representative who believes they have material inside information may not reveal that information to anyone except the supervisor or another principal, and it must be reported, through the broker-dealer's compliance department, to the exchange that trades the security. The broker-dealers must create written policies, known as information barriers (formerly called Chinese walls), to stop material inside information from flowing between certain departments. For example, there should be information barriers/ Chinese walls established between the firm's research department and sales department.
Liquidity (Marketability) Risk
The risk resulting from the lack of marketability of an investment that cannot be sold quickly enough to prevent or minimize a loss, or benefit from a potential gain, is a _____. This occurs when there are no ready buyers in the market for a particular security.
Business Risk
The risk that a company will not have adequate cash flow to meet its operating expenses is called a business risk. If a company goes into bankruptcy, an investor will lose the amount invested. It is also referred to as selection risk, because the investor assumes the risk of selecting a company that experiences liquidity challenges. Investors often spread their money out among several investments. Some may fail, some may flourish. One type of investment may do well at certain times while another may do well during different periods. The concept of investing in several different securities is known as diversification. Diversification reduces selection risk. Business risk is considered a non-systematic risk since it affects that business in particular and not the whole market.
Social or Political Risk
The risk that an investment's returns could suffer as a result of political changes, social events or instability in a country is a social or political risk. Instability affecting investment returns could stem from a change in government, legislative bodies, other foreign policy markets, military control, and excessive debt. Political risk is a factor of greater concern as the time horizon of an investment gets longer. The outcome of a political risk could lower investment returns or even remove the ability to withdraw capital from an investment. As the world's stock markets become more interconnected, the U.S. stock market is becoming less insulated from this form of risk.
Reinvestment Risk
The risk that future proceeds will have to be reinvested at a lower potential interest rate is a reinvestment risk. The term usually is used in the context of bonds and preferred stocks. Reinvestment risk is most evident during periods of falling interest rates in which coupon payments received are only capable of being reinvested at lower yields.
Defensive Investment Strategy
This is a method of portfolio allocation and management aimed at minimizing loss of principal. Defensive investors place a high percentage of their investable assets in bonds, cash equivalents, and stocks that are less volatile than average. A defensive strategy typically means a low risk/low return investment portfolio.
Aggressive Investment Strategy
This is a method of portfolio management and asset allocation that attempts to achieve maximum return primarily through capital appreciation. Since the investor's aim is growth, a higher percentage of their assets are in equities rather than in debt securities. A very aggressive portfolio would hold no debt. An investment strategy must meet the objectives and means of an investor.
Know Your Customer
Under FINRA's Know Your Customer rule, registered representatives and member firms must use due diligence to obtain essential information to service the customer's account, follow the customer's instructions, and to comply with all laws and regulations. To verify that the correct information was collected, the RR must send a copy of the customer profile or account record to the customer within 30 days of opening the account or with the customer's next statement. Updates and account information verification must be sent to the client at least every 36 months. Know your customer prior to making a recommendation.
Expenses
What are the individual or couple's spending habits? Do they have credit card balances, car loans, student loans or other debt? Can any unnecessary expenses be eliminated? Does the individual or couple have a budget or need to put one together?
Senior Citizen Suitability
When evaluating a customer's profile and performing a suitability determination, it is important to consider the customer's age, life stage, time horizon, goals, and risk tolerance. When working with senior citizens, member firms do not have an obligation to shield customers from risks they want to take. Making sure the customer is aware of all pertinent risks, costs, and rewards associated with products and strategies is very important. FINRA does not prohibit specific recommendations to senior citizens, provided they are suitable, however there are certain red flags that will cause additional scrutiny. The following recommendations are all considered potential red flags: Variable annuities and equity indexed annuities, RELP and other DPPs with limited liquidity and high risk & Speculative investments of high risk
Painting the Tape
When manipulative trading involves a series of purchases, or a series of sales, rather than paired buys and sells, the activity is known as ______, or ghosting. This is also illegal, since the intent is to give the false appearance of a trend in a stock's price and lure other investors into the same trading activity.
Share Class Recommendation for Mutual Funds
When selling or recommending mutual funds, registered representatives must provide investors with information about mutual fund classes. Mutual funds might offer more than one class of their shares to investors including shares with front-end sales charges (Class A), contingent deferred sales charges (Class B), or level load sales charges (Class C).
Matched Sales
When two or more parties are involved in a pattern of buying and selling a security merely to give the appearance of active trading, this is engaging in matched sales. Whereas there is usually only one manipulator in a wash trade, matched sales involve two or more conspirators.
Portfolio Rebalancing
While a well-diversified portfolio may help to eliminate or lessen some of the risks, it is also important to consider rebalancing that portfolio over specific intervals of time. Certain investments held within the portfolio may outperform others which could cause an investor's portfolio to become more or less risky than desired. The primary reason to rebalance a portfolio is to make sure it stays in line with the investor's risk profile and investment objectives. There are several ways to rebalance a portfolio. Passive rebalancing is a type of automatic rebalancing that removes dollars from the overperforming assets and reallocates them to the underperforming assets. This can be done on an annual or quarterly basis. Active portfolio rebalancing requires the portfolio manager to remove dollars from the underperforming assets and to pick those assets the manager believes will outperform.
Assets
are a resource with economic value that the client owns or controls with the expectation that they will provide a benefit. Assets can generate cash flow.
Liquid Assets (Cash Reserves)
are those that can be converted to cash quickly and easily (even if surrender charges or penalties apply). Personal liquid assets include savings and checking accounts, annuities, mutual funds, stocks and bonds. Investors should not consider making long-term investments until they have established cash reserves to take care of emergencies.
Annualized Return
demonstrates how much money a security earned each year for a specific period. Although the annualized return does not indicate the volatility of the security, it is a great hypothetical for possible performance. Annualized returns become a more valuable data source the longer the investor plans on holding their investment.
Taxation (Taxability) Risk
exists when income tax laws change, causing unfavorable tax consequences to securities investors. Example: Congress can choose to tax investment income at higher personal income tax rates rather than more favorable capital gains tax rates. Municipal Bonds have the greatest taxation risk because a change in tax laws would impact them the most.
Capital Risk
hat is not guaranteed is subject to capital risk.
Monthly Income Statement
illustrates the disposable and discretionary income available for a customer. Here is an example of a customer's monthly income statement:
Excessive trading activity
in a customer's account is often referred to as churning, twisting, or overtrading. There are no specific standards to measure excessive activity in customer accounts because this must be related to the objectives and financial situation of the customer involved.
Total Return
includes interest, dividends, capital appreciation, and distributions. This return assumes the investor reinvests all distributions. For a bond, the yield to maturity represents the total return, including interest income, and the gain or loss from the purchase price is included. With regards to stock, total return includes the capital gain or loss and any dividends received.
Market Rumors
involve spreading false, exaggerated, or misleading information about companies to influence the market price. The internet has become a common place for this prohibited and illegal behavior
Wash Trade
involves the simultaneous purchase and sale of the same security. The intent of this action to give the appearance of active trading without an actual change in beneficial ownership.
Marking the Open/Marking the Close
is a form of market manipulation that involves attempting to influence market prices. Marking the close involves executing purchase or sales orders at or near the close of normal trading hours. This activity can give an inflated or depressed closing price for that security and may affect the price of any orders that haven't been filled yet. Orders that are placed at slightly higher prices or sales orders at lower prices intended to drive up or suppress the price of the securities when the market just opened would be marking the open. Both of these actions are considered fraudulent and are prohibited activities.
Commingling
is a prohibited illegal practice that occurs when a broker-dealer or registered representative combines their securities and/or money with client's securities and/or money. This prohibition includes an RR "borrowing" from a customer, unless the customer is a lending institution. Example John is a registered representative with a broker-dealer. Mary, one of John's clients, sends John $10,000 to deposit in her mutual fund account. Instead of John depositing the money into a money market fund or returning the check, John deposits the check into either the brokerdealer's principal bank account or his own account.
Risk-Free Rate
is a return where it is assumed that there can be no losses and is extremely safe. Most analysts use Treasury bills for this measure. They are safe and have short maturities.
Age
is an important starting point when evaluating a customer's financial needs and suitability for various investment products. Many older investors tend to have more conservative objectives/goals and a shorter time horizon, while younger investors are often more aggressive. Age is only one factor used when evaluating a customer's risk tolerance level. Individuals of the same age may vary dramatically in their attitudes toward, and their ability to tolerate risk.
Further Diversification
is available among different classifications of stock. Those classifications are known as large-cap, mid-cap, and small-cap (cap is short for capitalization). These terms refer to the level of capitalization of a publicly traded corporation. Large-cap stocks have a market capitalization of $10 billion and higher. Mid-cap stocks have a market capitalization between $2 billion and $10 billion, and small-cap stocks are less than $2 billion. Markets can favor a specific capitalization category at different times. Large-cap stocks tend to outperform the other two categories when the economy is contracting due to their size and established profile. When the economy is growing small-cap stocks can outperform the other two. Therefore, a diverse portfolio will include these various classifications of stock in consideration of market fluctuations. Diversification may also include growth and value stocks. A growth stock is a fast-growing stock. A value stock is one that is purchased below its potential value. In addition, large-cap, mid-cap, and small-cap stocks may be purchased among the two categories of growth and value, thereby enhancing diversification. International stocks may also provide further diversification through taking advantage of currency (exchange rate) risk. Currency risk is the inverse relationship between foreign currency and the U.S. dollar. When the U.S. economy is in a decline and the U.S. dollar value decreases, foreign stock prices will rise. Diversification can also occur when comprising a portfolio that includes bonds with various maturities such as, short-term, mid-term and long-term bonds. Selecting bonds from different issuers such as the United States Government, municipal governments, government agencies, and corporate bonds can provide the portfolio with debt instruments that vary regarding credit quality.
Prepayment Risk
is common to mortgage or loan-backed securities. If interest rates in the market drop, borrowers may refinance their loans at lower interest rates. This will cause the existing loans to be paid off earlier than anticipated and would cause the securities holding these loans to be retired ahead of schedule.
Averages
is composed of a small number of issues considered representative of the market. The Dow Jones Average is probably the most commonly known. The Dow Jones Average is composed of 65 issues; 30 industrials, 15 Utilities, and 20 Transportation. When the phrase "the Dow" or "the market" is used, what is usually being referred to is the Dow Jones (30) INDUSTRIAL Average. ("The Dow is up four points today", or "the market hit 10,000 last week").
Indexes
is composed of many issues whose prices are tracked on a regular basis. A broadbased index is designed to represent the whole stock market with a broad segment of the stock market represented (such as all stocks trading on a specific exchange). A narrow-based index represents a specific industry (such as computer technology). The S&P 500 index is a market value weighted index composed of 500 stocks from large capitalization companies. The NYSE Composite Index is composed of more than 1,900 common stocks trading on the New York Stock Exchange (no bonds or preferred stock). Other indexes include the S&P 100, the Russell 2000, and the Wilshire 5000.
Discretionary Income
is the amount of an individual's income that is left for spending, investing or saving after taxes and personal necessities (such as food, shelter, and clothing), and debts have been paid. This includes money spent on luxury items, vacations, and non-essential goods and services. When economic output is strong, discretionary income levels tend to be high as well. If inflation occurs in the price of life's necessities, then discretionary income will fall, assuming that wages and taxes remain relatively constant. Total income - expenses = discretionary income
Disposable Income
is the amount of money that a household has available for spending and saving after income taxes have been accounted for. It is independent of all costs that need to be paid out in order to survive. Disposable personal income is often monitored because it is a key economic indicator used to gauge the overall state of the economy. Example: If a household's personal income from salaries is $100,000 and the tax rate is 30%, the disposable income is $70,000.
Volatility
is the frequency and size of fluctuations in a security's value compared to changes in the overall market. Volatility is measured in terms of "beta". Beta describes the likely movement of a security compared to the market: Higher beta means that the price of the security is more likely to rise or fall dramatically over a short time period; lower beta means that a security's value does not fluctuate as dramatically or as frequently. A security with high volatility (higher beta) should only be recommended to an investor with a suitable risk tolerance level.
Risk tolerance
is the investor's attitude toward a negative change in the value of their invested portfolio. Investor's risk tolerance varies according to age, income requirements, time horizon and financial goals. Every investor is unique, so each investor's past investment experience must be taken into consideration.
Hedging
is the method used to reduce systematic risk. Options on broad-based indices can be purchased to protect an investor from overall market decline. An investor could purchase puts on the S&P 500, for example. If the market drops, the investor exercises the put, reaps the benefits of the market drop, and lessens their losses on their long stock positions. Investors can also hedge by short selling in a falling market. This cannot be done with mutual funds but can be done with ETFs that mirror an index. Again, if the market drops, the investor will profit from the decline on their short ETF position and offset the losses on their long positions.
Credit (Default) Risk
is the possibility that an issuer will be unable to pay back the interest and/or principal due to its creditors. A borrower who misses a payment is said to be in default. Some fixed-income securities such as U.S. Treasuries are considered to have virtually no risk of default. At the other end of the spectrum, high-yield (junk or speculative) bonds are considered more likely to miss a payment.
Market risk (systematic risk)
is the possibility that the value of an investment will fall due to a decline in the market as a whole and is unrelated to any adverse conditions of an issuer. A systematic risk is inherent to investing in the market. Since the entire market is affected, diversification will not protect from this type of risk.
Diversification
is the process of allocating funds among different securities, industries, asset classes, and geographical locations to minimize risk in an investment portfolio. Diversification will reduce non-systematic risk in a portfolio so that the positive performance of some investments will neutralize the negative performance of others. It does not guarantee a profit or prevent a loss. Example: A $10,000 common stock investment in three separate corporations will produce a 1/3rd loss of investment if one of the corporations becomes bankrupt. However, using the same $10,000 investment to purchase a mutual fund that owns shares in 50 to 60 different corporations provides a good amount of diversification for the investment. If one of the corporations held in the mutual fund files for bankruptcy, it does not hurt the $10,000 investment as it would with the portfolio that holds just three securities.
Interest Rate Risk
is the risk that an investment's value will change inversely to changes in the general economy's interest rates (as interest rates rise, bond prices fall and vice versa). Interest rate risk affects the value of bonds more directly than stocks, and it is a major risk to all bondholders. The market is always comparing the interest rates offered on new bonds to those that were previously issued.
Duration
is the tool used to determine the price sensitivity of a bond based on a small interest rate change. A bond with a higher duration number will carry a higher interest rate risk than a bond with a lower duration number. Bonds with a longer maturity and/or a lower coupon rate carry a higher interest-rate risk and will have a higher duration number. Bonds with a shorter maturity and/or higher coupon rate carry a lower interest-rate risk and will have a lower duration number.
Insider Trading
is using material nonpublic information about an issuer while engaging in securities transactions or making buy/sell recommendations. As in other parts of the federal securities laws, "material" refers to information that an investor would find important in making a buy or sell decision about the security. "Nonpublic" means that the general public does not have access to the information. When publicly traded corporations have material information, that information must be made available to the public. The Act of '34 narrowly defines an insider as anyone with access to inside information, including the issuer's owners, partners, officers, directors, shareholders with more than 10% ownership, accountants, attorneys, employees, and immediate family members of any of these persons. The definition also includes employees of law firms, banks, broker-dealers, and printing companies who were provided information based on delivering professional services to the issuer. Persons trading on that information before it is public are in violation of the provisions of the Securities Exchange Act of 1934 and the Insider Trading Act. Persons cannot even transmit material inside information to others.
Front Running
occurs when a broker-dealer or registered representative trades ahead of a large customer order that may affect the price of the security. If the customer order causes the price of the security to rise in the market, the firm or the RR would then sell that position at a profit. This is a prohibited practice since the firm or RR is profiting at the customer's expense.
Trading in mutual fund shares
on a short-term basis when encouraged by an RR raises the question of a rule violation since normally these securities are not proper trading vehicles.
Liabilities
represent a client's debts or obligations and refers to any money or service that is currently owed to another party. Personal liabilities include mortgages, other loans, and outstanding bills, such as unpaid credit card balances.
Non-Systematic Risks
represents the risk associated with a specific security, company, or industry, not the return of the overall market. These risks can be lessened or eliminated through diversification. Example: If there are only a few corporations in the pharmaceutical industry and the industry is under pricing pressures, addressing that risk could include the purchase of other stocks outside of the industry or by diversifying among the pharmaceutical stocks that are not affected.
Inflation-Adjusted Return
subtracts the inflation rate from the return. The inflation rate used is for the time period held and is based on the consumer price index (CPI). Inflation-adjusted return is also known as the real return.
Recommending speculative low-priced securities
to customers without knowledge of—or attempting to obtain—information concerning the customers' other securities holdings, their financial situations and other necessary data involves a high probability that the recommendation will not be suitable for at least some of the persons solicited. This is applicable to telephone sales campaigns. I
