Unit 19
An IAR has set up the initial meeting with a prospective advisory client. An important part of that meeting is gathering client data. Of the following items, which is generally considered to be the most important for preparing suitable recommendations?
Risk tolerance Although each of the choices represents information that is part of the data gathering process, an IA cannot make suitable recommendations without knowing the investor's risk tolerance.
In general, the first step an investment adviser should take with a new client is
information gathering Until the investment adviser has gathered the necessary information, no recommendations can be made. An explanation of the risks comes after gathering the information because that informs the IA of the investor's risk tolerance and investing experience.
An investment adviser would be least likely to gather financial planning information about a client from
the client's Tweets. There are a number of ways to gather information about your client's financial resources, but it is highly unlikely that a social media page would be one of them.
John and Jane have a net worth of $20,000 and total assets of $150,000. If their revolving credit and unpaid bills totals $8,000, how much are their total liabilities?
$130,000 The balance sheet formula is assets − liabilities = net worth. Therefore, $150,000 − liabilities = $20,000, where liabilities = $130,000. Did you answer $122,000? That is the amount of the liabilities other than the revolving credit, but that is not what the question is asking for.
You are doing an investment plan for a new client, age 55, who plans to retire at age 70. The client is somewhat risk averse and wants to preserve capital while at the same time not falling prey to possible inflation. Which of the following portfolios would probably be most suitable?
60% high-quality bonds; 30% large-cap stocks; 10% cash equivalents Although it is possible to debate this choice (but don't), NASAA would suggest that the bonds and cash offer sufficient capital preservation while this proportion of equities will combat the risk of inflation. High-yield (junk) bonds have no place in the portfolio of a risk-averse investor.
Among investor objectives is preservation of capital. Which of the following would be most appropriate for inclusion in the portfolio of this kind of investor?
A money market fund Preservation of capital means no fluctuations. Money market funds are the only logical choice here. True, the Treasury bonds do not have default risk, but because they can have maturities as long as 30 years, they are subject to interest rate risk.
Any recommendations made to customers by a broker-dealer must be suitable for the customer on the basis of an investigation of the customer's investment objectives financial status ability to pay high commissions desirability as a customer
I and II Recommendations must meet the needs of the customer, not necessarily those of the agent or the broker-dealer firm.
You are onboarding a new client. Which of the following is the least important indicator of the client's risk tolerance?
Highest education level Although those with more education might be able to understand the concept of risk versus reward, it is far more important to know the client's age, time horizon (expected retirement date helps there), and attitude toward taking a loss.
It is generally accepted that agents and IARs will give greater consideration to which of the following when making recommendations to their senior clients? Age Life stage Retirement savings Tax status
II and III All of these are important suitability considerations for all customers. But when it comes to seniors, it is felt that life stage (including whether the customer is employed, retired, or nearing retirement) and current retirement savings relate particularly to seniors.
If a customer's chief concern is to shelter as much of his portfolio earnings from tax as possible, which of the following securities would be most suitable?
Municipal GOs The interest on municipal GOs is exempt from federal income tax and perhaps state income tax, depending on the investor's residency.
An elderly client explains to you that he is risk averse and wishes to find an investment that will provide him with preservation of capital. Which of the following might you recommend?
Bank-insured CDs Preservation of capital is almost always a sign that the client needs CDs. Sure, the U.S. government bonds will pay back the principal when due, but with long-term maturities, there will be plenty of interest rate risk that could affect the client if he needs the capital prior to maturity
Low risk tolerance and high liquidity needs are typical characteristics of which type of institutional investor?
Banks As with so many suitability questions, students frequently have to sit back and try to find a logical answer. Although the risk tolerance for all of these choices tends to be on the lower end of the scale, banks are different when it comes to liquidity needs. Banks tend to have high liquidity needs because they must be ready to meet withdrawals at any time by depositors. The nature of foundations, defined benefit pension plans, and trusts is such that they typically have lower liquidity needs than banks.
Which economic concept attempts to explain why investors behave irrationally?
Behavioral finance There is a premise that investors are irrational when it comes to making investment decisions. The study of this is known as behavioral finance.
Your client is 75 years old and has $100,000 to invest. He enjoys a relatively high income and is not concerned with immediate liquidity, although he is risk averse. The most suitable asset allocation strategies listed below would be A)
a 50% municipal bond fund, 40% government bond fund, 10% large-cap common stock fund The allocation of 50% municipal bond fund, 40% government bond fund, and 10% large-cap common stock is appropriate for a high-income person of age 75 who is not concerned with liquidity. The 10% large-cap fund provides some inflation protection with very moderate downside risk.
An individual investor specifies to her investment adviser representative that her portfolio must produce a minimum amount of cash each year. This would be considered
a liquidity constraint. Liquidity constraints arise from an investor's need for spendable cash.
Years ago, following your advice, a client opened a 529 Plan to save for their son's college education. The child is now about 3 years from beginning his freshman year. The client, believing that the stock market is currently undervalued, wishes to reallocate the plan assets so that most of the funds are in a broad stock market index portfolio. At this time, your advice would probably be against this allocation because of
market risk This short time horizon is a serious constraint and a portfolio that is largely equities, subjects the account to too much market risk. If the child had been 5 years of age, giving the client a 13-year time horizon, this would have made more sense.
If a customer purchases shares in a municipal bond fund, which of the following statements are true? Dividends are subject to federal income tax Dividends are not subject to federal income tax Capital gains distributions are subject to federal capital gains tax. Capital gains distributions are not subject to federal capital gains tax.
II and III Dividends distributed by municipal bond funds are federal tax free (and in some cases, state tax free as well) in alignment with the tax rules of how the fund's investment income was earned. However, any capital gains distribution resulting from the sale of bonds held long term by the fund is subject to capital gains taxation to the shareholder.
If a client wanted an investment that would eliminate interest risk as to principal, you would recommend
a bank-insured certificate of deposit Because bank-insured CDs are nonnegotiable (we're not discussing the $100k minimum jumbos), there is no market fluctuation caused by changes in interest rates as with marketable securities. If you invest $10,000, you will always get back that $10,000 whenever you cash in the CD, regardless of current interest rates. This is true even when cashing in early. There may be a prepayment penalty, but that is considered separate from interest rate risk. TIPS offer inflation protection and preferred stock is interest rate sensitive in the same manner as a bond. The 91-day T-bill doesn't have much interest rate risk, but if an investor was to attempt to liquidate the holding prior to maturity and interest rates increased, there could be a loss.
An investment adviser representative meets with a couple who explains that they wish to be able to pay for their daughter's college education. The IAR is told that the child will be starting school in 5 years. This 5-year time period would be considered
an investment constraint Investment constraints are limitations on the ability to make use of particular investments. They can be liquidity, time horizon, tax concerns, legal and regulatory factors, and unique circumstances (ethical objectives or social responsibility considerations). The easiest way to determine if it is a constraint or a capital need is if a dollar amount is stated. When a specific sum is mentioned, it is a capital need. The IAR might use a present value computation to determine the amount to be deposited,, and this may be part of the client's IPS, but neither of those answers the question posed.
A client with 25 years until retirement should invest primarily in
common stocks This client's time horizon is quite long. With 25 years until retirement, the customer should invest primarily in stocks. Historically, over long time periods, equity securities have provided the greatest returns.
A client excitedly calls his investment adviser with the news that he is now going to handle his own investments. "I just read some great investment books and now I know what to do." Based on the study of behavioral finance, it would appear that this individual is
overconfident. The behavioral finance bias of overconfidence refers to the observation that experienced (and even some "rookie") investors tend to overestimate their ability and the accuracy of the information available to them.
It would be CORRECT to state that when an investor has a shorter time horizon,
the need for liquidity is more important When the time horizon is short, there is a greater need for access to the funds now. Therefore, liquidity is a major consideration. With a short time horizon, the investor can take less risks (and won't have to because there will be less exposure to inflation risk).
An investment adviser should develop an investment policy based on the needs and objectives of the client. When the client is a business entity structured as a general partnership, the investment policy would have to consider
the objectives of all the partners on a collective basis Because all income and gains pass through to the partners, and because there is unlimited personal liability for all general partners, we must examine the objectives of each of them to determine proper suitability.
Tactical Evaluation and Research (TEAR), a federal covered investment adviser, suggests the purchase of stock in a major tobacco company. The client explains that he doesn't want to invest in tobacco stocks because his father passed away from lung cancer. What kind of reason is this?
Values Because of the negative association with tobacco, this client's values are such that he would avoid owning stock in a tobacco company. Why not environmental? That isn't specific enough because growing tobacco is not an environmental issue and this client's personal experience has shaped his values.
Your retired 72-year-old client still lives in the home he purchased 35 years ago for $40,000. It is currently valued at $700,000 and there is no mortgage. The client has almost $500,000 in his self-directed IRA rollover account. When determining suitable investments for this client, you would base your recommendations on the fact that the client is an accredited investor having a net worth in excess of $1 million a home equity loan could more than double the amount of funds available to invest as a retiree, any losses suffered cannot be made up from current income the client's time horizon could be as long as 20 years
III and IV One of the risks facing senior investors who are retired is that, unlike those still employed, loss of principal can be devastating. With today's medical advances, a 72-year-old can be looking at 15 to 20 additional years of life. Therefore, recommendations must be made to maximize the probability of the client's assets lasting that long. Effective with the Dodd-Frank Act of 2010, this investor is no longer accredited because the value of the primary residence must be excluded from the net worth computation. And, even if he were, eligibility does not equal suitability.
Your elderly client has $10,000 to invest and seeks preservation of capital and a moderate income stream. If she has never invested in mutual funds before and all of her savings are in bank CDs and saving accounts, you should recommend
a money market fund A money market fund is the most appropriate for an elderly person seeking preservation of capital and some income on a regular basis. A T-bill, although safe, provides interest income only at maturity. Because the client has never invested in mutual funds before, she may be uncomfortable with the potential fluctuations in principal of the bond funds. This exam will not want you to go so far as to claim, "but if the client purchased 4-week T-bills, there would be the ultimate safety and income every 28 days." No client with this background is going to be trading every month—don't go there.
A newlywed couple in their 20s with a combined annual income of $46,000 recently opened individual IRA accounts with you and deposited $100 into each to get the accounts started. One month later, you receive a call from them telling you they have received a six-figure inheritance and are now able to fully fund those IRAs. The most suitable recommendation for the couple is to
invest $5,900 into a stock index fund in each IRA account and place the remaining funds in a money market account until their new financial situation can be evaluated. The couple's new IRA accounts are an indicator that retirement savings is a primary goal. That is why it makes sense and is suitable to make the maximum contributions as soon as possible. With $100 already in the account, adding $5,900 reaches the $6,000 maximum. Because the funds were unexpected, it would be prudent for the couple to place the additional funds in a liquid money market account until they have time to reevaluate how this windfall may change their financial objectives and goals. There is no indication that the couple has a high risk tolerance, so an aggressive stock fund would be unsuitable, as would tax-free municipal bonds based on the couple's income level. Variable annuities may be suitable but are not the most suitable answer choice in this case because those are generally not an appropriate investment in an IRA. Please note that only earned income can be used to determine the eligible contribution to an IRA and their $46,000 is more than enough to allow $6,000 in each account. The IRS doesn't care where the money is coming from (in this case the inheritance) as long as there is enough earned income.
