Customer Recommendations, Professional Conduct, and Taxation

TOTTEN TRUST To establish a Totten trust, the grantor simply goes to the bank and fills out paperwork naming the beneficiaries to receive the funds in the event of the grantor's death. The grantor may easily change the beneficiaries by simply filling out new paperwork at the bank. The funds will pass directly to the beneficiaries and will not go through probate.

A Totten trust is effectively a pay-on-death account opened by a grantor or settler at a bank. This type of trust is incredibly easy to open.

Corporations An S corporation allows the income to flow through to the owners and to be taxed as ordinary income. No more than 100 people can own an S corporation, and the S corporation must be organized as a domestic corporation.

A corporation is its own legal entity and has a perpetual life independent from its owners. How the corporation is taxed depends upon how the corporation is organized. C corporations are taxed at the corporate rate independent from the owners' tax rates.

Speculation Some of the more speculative investments are: Penny stocks. Small cap stocks. Some growth stocks. Junk bonds.

A customer investing in a speculative manner is willing to take a high degree of risk in order to earn a high rate of return.

Family limited partnership Usually the parents will act as the general partners and will transfer limited partnership interests to their children. As the interests are transferred to the children the parents may become subject to gift taxes. However, the gift taxes will usually be lower than they would have suffered without the partnership.

A family limited partnership is often used for estate planning. Parents may place significant assets into a family limited partnership as a way to transfer their ownership.

Limited partnership The limited partners put up the investment capital required but may not exercise management or control over the partnership.

A limited partnership consists of at least one general partner and one or more limited partners. It is the duty of the general partner to manage the partnership in accordance with the partnership's objectives.

Painting the tape

A manipulative act by two or more parties designed to create false activity in the security without any beneficial change in ownership. The increased activity is used to attract new buyers.

Capping

A manipulative act designed to keep a stock price from rising or to keep the price down.

Pegging

A manipulative act designed to keep a stock price up or to keep the price from falling.

Partnerships

A partnership is an association of two or more people who are either in business together or who hold assets in a partnership. The partnership agreement will detail each partner's ownership interest and authority to act on behalf of the partnership.

Omitting Material Facts The adviser may, however, omit an immaterial fact.

A representative may not omit any material fact, either good or bad, when recommending a security. A material fact is one that an investor would need to know in order to make a well-informed investment decision.

Beta A stock with a beta greater than 1.0 has a higher level of volatility than the market as a whole and is considered to be more risky than the overall market. A stock with a beta of less than 1.0 is less volatile than prices in the overall market and is considered to be less risky. An example of a low beta stock would be a utility stock. The price of utility stocks does not tend to move dramatically. A security's beta measures its nondiversifiable or systematic risk. For each incremental unit of risk an investor takes on, the investor must be compensated with additional expected returns. If the portfolio's actual return exceeds its expected return, the portfolio has generated excess returns.

A stock's beta is its projected rate of change relative to the market as a whole. If the market was up 10% for the year, a stock with a beta of 1.5 could reasonably be expected to be up 15%. This is the simplest way to calculate expected return using beta. However, if the question provides you with a risk-free return, you must subtract the risk-free return from the market return to determine the risk premium. From there, multiply the beta times the risk premium and add back the risk-free rate to predict the precise expected return for the security or portfolio. If using the same example of a stock with a beta of 1.5 and a market return of 10%, you are provided with the risk-free rate of 1% for the 90-day T-bill, your calculation would be as follows: Market return minus the risk-free rate (10-1) equals a risk premium of 9%. 9% multiplied by the beta of 1.5 equals 13.5%. Finally, add back the risk free rate of 1% , to determine the overall expected return, which in this example would be 14.5% found as follows ( 10-1) x 1.5 +1 =14.5%.

Alpha Portfolio managers whose portfolios have positive alphas are adding value through their asset selection. The outperformance as measured by alpha indicates the portfolio manager is adding additional return for each unit of risk taken on in the portfolio A portfolio manager's relative under performance would result in negative Alpha.

A stock's or portfolio's alpha is its projected independent rate of return or the difference between an investment's expected (benchmark) return and its actual return.

Withholding Tax

All broker dealers are required to withhold 31% of all sales proceeds if the investor has not provided a Social Security number or a tax identification number. Similarly, 31% of all distributions from a mutual fund will also be withheld without a Social Security number or a tax identification number.

Fair Dealings with Clients An investment adviser may not employ or engage in: Churning. Manipulative and deceptive devices. Unauthorized trading. Fraudulent acts. Blanket recommendations. Selling dividends. Misrepresentations. Omitting material facts. Making guarantees. Recommending speculative securities without knowing whether the customer can afford the risk. Short-term trading in mutual funds. Switching fund families.

All investment advisers are required to act in good faith in all of their dealings with customers and are required to uphold just and equitable trade practices.

Investment Objectives Some of the different investment objectives are: Income. Growth. Preservation of capital. Tax benefits. Liquidity. Speculation.

All investors want to make or preserve money. However, these objectives can be achieved in different ways.

Customer Complaints When a written complaint is received by mail or e-mail, the customer who has issued the complaint must be notified that the complaint has been received. If a customer files a complaint and subsequently withdraws the complaint, the firm is still requested to maintain the correspondence relating to the complaint in the firm's complaint file.

All written complaints received from a customer or from an individual acting on behalf of the customer must be reported promptly to the principal of the firm. The firm must maintain a separate customer complaint folder even if it has not received any written customer complaints. If the firm's file contains complaints, the file must state what action was taken by the firm, if any, and it must disclose the location of the file containing any correspondence relating to the complaint.

Misrepresentations

An adviser may not knowingly make any misrepresentations regarding: A client's account status. The representative. The firm. An investment. Fees to be charged.

Recommending Mutual Funds The highest sales charge charged by the fund The fund's current yield based on dividends only A graph of the performance of the fund versus a broad-based index The performance of the fund for 10 years or the life of the fund, whichever is less No implication that a mutual fund is safer than other investments The sources of graphs and charts

An adviser recommending a mutual fund should ensure that the mutual fund's investment objective meets the customer's investment objective. If the mutual fund company or broker dealer distributes advertising or sales literature regarding the mutual fund, the following should be disclosed:

Net Present Value The interest rate environment in which the NPV is calculated has a large influence on the present value of a future payment. If a higher interest rate is used in the NPV calculation, it will cause a greater discount to be applied to the future payment. Higher interest rates will cause future payments to be less valuable, whereas lower rates will cause the future payments to be discounted less and to be more valuable. The formula for calculating an investment's NPV is as follows: NPV = NPV of future cash flows - NPV of cash outflows The cash outflow in the above calculation equals the amount of money required to be invested to purchase the investment. If the NPV calculation results in a positive number, the investment should be made.

An investor may calculate the net present value (NPV) of an income-producing investment by discounting the series of future payments produced by the investment into the current value of one lump sum. When calculating the current value of a future stream of dividend or interest payments, the investor will take into consideration the amount of time until the payments are received as well as the overall interest rate environment. Payments that are made further out on the time horizon are discounted more heavily than payments received sooner and are therefore less valuable.

Average Cost Once an investor has elected to use the average cost method to calculate gains and losses, the method used to calculate future gains and losses may not be changed without IRS approval.

An investor may decide to sell shares based on the average cost. The average cost can be determined by using the following formula: average cost = Total dollars invested / total # of shares purchased

Deducting Capital Losses Any net capital losses that exceed $3,000 may be carried forward into future years and may be deducted at a rate of $3,000 from ordinary income every year until the loss is used up. If the investor has a capital gain in subsequent years, the investor may use the entire amount of the net capital loss remaining to offset the gain up to the amount of the gain.

An investor may use capital losses to offset capital gains dollar for dollar in the year in which they are realized. A net capital loss may be used to reduce the investor's taxable ordinary income by up to $3,000 in the year in which it is realized.

PERPETUAL INCOME ACCOUNTS EXAMPLE: If an investor wanted to generate a monthly income of $2,000 in perpetuity, the annual income benefit would be $24,000. If the investor was placing the money in an account with a fixed rate of 6%, the investor would have to place $400,000 in the account, found as follows: $24,000 / .06 = $400,000

An investor may wish to establish a fixed income for themselves, their spouse, a child, or a grandchild with the objective of providing the income forever. An account may be established to provide perpetual income or income in perpetuity based on some simple calculations. If the investor knows the desired income level to be provided and the interest rate the account will generate, the lump sum needed to fund the account may be calculated. To determine the lump sum needed, divide the annual income benefit by the annual interest rate.

Share Identification

An investor may, at the time of the sale, specify which shares are being sold. By keeping a record of the purchase prices and the dates that the shares were purchased, the investor may elect to sell the shares that create the most favorable tax consequences.

Donating Securities to Charity If the securities were held less than 12 months, the investor will be responsible for taxes on the appreciation. The recipient's cost base will be equal to the value of the securities on the day it received the gift.

An investor who donates securities to a charity will receive a tax deduction equal to the value of the securities. If the investor has an unrealized gain and has held the securities for more than 12 months, the investor will not owe any taxes on the appreciation.

WEIGHTED RETURNS The dollar-weighted return method can be used to determine the IRR of the portfolio by taking into consideration the cash flows in and out of the account. If the investor will not be making additional contributions to or making withdrawals from the account, the investor may use the time-weighted return method to determine the IRR of the portfolio.

An investor who is evaluating the performance of a portfolio manager must take into consideration the impact that any contributions or withdrawals made by the investor will have on the overall performance of the account. In evaluating the performance of a manager who is overseeing an account where the investor will be making contributions and withdrawals, the investor should evaluate the performance by using the dollar-weighted return method.

Unauthorized Trading

An unauthorized transaction is one that is made for the benefit of a customer's account at a time when the customer has no knowledge of the trade and the adviser does not have discretionary power over the account.

Modern Portfolio Theory Asset rebalancing can be divided into two categories: systematic rebalancing and active rebalancing. Systematic rebalancing is designed to keep the original asset allocation model in place. For example, if a client's portfolio is designed to be 70%, 25%, and 5% in stocks, bonds, and cash, respectively, as the percentages shift, the portfolio manager would rebalance the assets to maintain the original percentages. Systematic rebalancing can be done at regular intervals, such as quarterly, or whenever the asset allocation shifts by a certain percentage, such as by 5% or more. Active rebalancing assumes that a portfolio manager can effectively shift the asset allocation to take advantage of shifts in the performance of the various asset classes. If an investor has the same original portfolio allocation of 70/25/5 and the portfolio manager thinks that the bond market will outperform all other investments, the portfolio manager may use tactical rebalancing to rebalance the portfolio as 40/55/5. Alternatively, investors may elect to employ a buy-and-hold strategy and let the allocations go where they may. This buy-and-hold strategy would reduce transaction costs and tax consequences.

As money management developed over the last century, analysts began to shift their focus from the returns available from individual investments to the returns available from an entire portfolio. This approach became known as modern portfolio theory. Modern portfolio theory is based on the concept that investors are risk averse. Through diversification of investments and asset classes, portfolios can be constructed with higher levels of expected return for each unit of risk assumed. Asset classes are divided into three main categories: stocks, bonds, and cash and cash equivalents. Portfolio managers, through modern portfolio theory, can construct portfolios based on various allocations over the three main asset classes whose return will be the greatest given each unit of risk. This level of optimal performance is known as the efficient frontier. Any portfolio whose returns are expected to be less than optimal are said to be operating behind the efficient frontier. Optimal portfolio performance will be achieved by constructing a portfolio whose securities' prices move independently of one another or whose prices move inversely to one another. Allocating a client's assets over various asset classes to achieve a given investment objective is known as strategic asset allocation. As the investment results of the different asset classes vary over time, the assets may have to be rebalanced.

Time Value of Money

As time progresses, inflation eats away at the value or the purchasing power of the dollar. That is to say that a dollar today is worth more than a dollar tomorrow. Investors can determine the future value of a sum invested if they know the interest rate, the time horizon, and the compounding schedule. The future value of a sum invested today can be determined by using the following formula: FV = PV (1 + R)T Where: FV = future value PV = present value R = interest rate T = the number of compounding periods for which the money will be invested

Borrowing and Lending Money Loans may be made between an agent and a customer if the customer is a bank or other lending institution, where there is a personal or outside business relationship and that relationship is the basis for the loan, or between two agents registered with the same firm.

Borrowing and lending of money between registered persons and customers is strictly regulated. If the broker dealer allows borrowing and lending between representatives and customers, the firm must have policies in place that will allow for the loans to be made.

Call Risk

Call risk is the risk that as interest rates decline, higher yielding bonds and preferred stocks will be called and investors will be forced to reinvest the proceeds at a lower rate of return or at a higher rate of risk to achieve the same return. Call risk only applies to preferred stocks and bonds with a call feature.

Capital Risk

Capital risk is the risk that an investor may lose all or part of the capital that has been invested. Investors who purchase securities are not assured of the return of their invested principal.

Alternative Minimum Tax (AMT) These items include: Interest on some industrial revenue bonds. Some stock options. Accelerated depreciation. Personal property tax on investments that do not generate income. Certain tax deductions passed through from direct participation programs.

Certain items that receive beneficial tax treatment must be added back into the taxable income for some high-income earners.

Credit Risk

Credit risk is the risk of default inherent in debt securities. An investor may lose all or part of an investment because the issuer has defaulted and cannot pay the interest or principal payments owed to the investor.

Fixed assets include: Plant and equipment. Property and real estate.

Fixed assets are assets that have a long, useful life and are used by the company in the operation of its business.

Tax Benefits

For investors seeking tax advantages, the only two possible recommendations are: Municipal bonds Municipal bond funds

Fraud Fraudulent acts include: False statements. Deliberate omissions of material facts. Concealment of material facts. Manipulative and deceptive practices. Forgery. Material omission. Lying.

Fraud is defined as any act that is employed to obtain an unfair advantage over another party.

Fundamental Analysis The balance sheet The income statement Financial ratios Liquidity ratios Valuation ratios

Fundamental analysts examine the company's financial statements and financial ratios to ascertain the company's overall financial performance. The analyst will use the following to determine a value for the company's stock:

Inherited and Gifted Securities If during the course of an investor's life, the investor gives securities to another person, the recipient will have two cost bases. The recipient's cost base for determining a capital gain will be the giver's cost base; the recipient's cost base for determining a capital loss will be the giver's cost base or the fair market value of the securities on the day the gift was made, whichever is less.

If an investor dies and leaves securities to another person, that person's cost base for those securities is the fair market value of the securities on the day the decedent died. The cost base of the original investor does not transfer to the person who inherited the securities. Any capital gain on the sale of inherited securities will be considered long term.

FIFO In many cases, this will result in the largest capital gain and, as a result, the investor will have the largest tax liability under this method.

If the investor does not identify which shares are being sold at the time of sale, the IRS will assume that the first shares that were purchased are the first shares that are sold under the FIFO method.

Interest Rate Risk

Interest rate risk is the risk that the price of bonds will fall as interest rates increase. As interest rates rise, the value of existing bonds falls. This may subject the bondholder to a loss if he or she needs to sell the bond.

Disclosure of Client Information If the client is an issuer of securities and the broker dealer is an underwriter, transfer agent, or paying agent for the issuer, then the broker dealer is precluded from using the information it obtains, regarding the issuer's security holders for its own benefit.

Investment advisers may not disclose any information regarding clients to a third party without the client's expressed consent or without a court order.

Wash Sales This is known as a wash sale, and the IRS will disallow the loss. In order to claim the loss, the investor has to have held the securities for 30 days and must wait at least 30 days before repurchasing the same securities or securities that are substantially the same. The total number of days in the wash sale rule is 61. Securities that are substantially the same include call options, rights, warrants, and convertibles.

Investors may not sell a security at a loss and shortly after repurchase the security, or a security that is substantially the same, to reestablish the position if they intend to claim the loss for tax purposes and deduct the loss from their ordinary income.

Investment Taxation A taxable event will occur in most cases when an investor: Sells a security at a profit. Sells a security at a loss. Receives interest or dividend income.

Investors must be aware of the impact that federal and state taxes will have on their investment results.

Growth The only investments that will achieve this goal are: Common stocks. Common stock funds.

Investors who are seeking capital appreciation over time want their money to grow in value and are not seeking any current income.

Cost Base of Multiple Purchases

Investors who have been accumulating shares through multiple purchases must determine their cost base at the time of sale through one of the following methods: -FIFO (first in, first out) -Share identification -Average cost

Opportunity Risk

Investors who hold long-term bonds until maturity must forgo the opportunities to invest that money in other potentially higher yielding investments.

Liquidity The following is a list from the most liquid to the least liquid: Money market funds Stocks/bonds/ mutual funds Annuities Collateralized mortgage obligations Direct participation programs Real estate

Investors who need immediate access to their money need to own liquid investments that will not fluctuate wildly in value in case they need to use the money.

Manipulative and Deceptive Devices Some examples of manipulative or deceptive devices are: Capping. Pegging. Front running. Trading ahead. Painting the tape/matched purchases/matched sales.

It is a violation for an adviser to engage in or employ any artifice or scheme that is designed to gain an unfair advantage over another party.

Blanket Recommendations Example: Mr. Jones, an agent with XYZ brokers, has a large customer base that ranges from young investors who are just starting to save to institutions and retirees. Mr. Jones has been doing a significant amount of research on WSIA Industries, a mining and materials company. Mr. Jones strongly believes that WSIA is significantly undervalued based on its assets and earning potential. Mr. Jones recommends WSIA to all his clients. In the next 6 months the share price of WSIA increases significantly as new production dramatically increases sales, just as Mr. Jones's research suggested. The clients then sell WSIA at Mr. Jones's suggestion and realize a significant profit. Analysis: Even though the clients who purchased WSIA based on Mr. Jones's recommendation made a significant profit, Mr. Jones has still committed a violation because he recommended it to all of his clients. Mr. Jones's clients have a wide variety of investment objectives, and the risk or income potential associated with an investment in WSIA would not be suitable for every client. Even if an investment is profitable for the client it does not mean it was suitable for the client. Blanket recommendations are never suitable.

It is inappropriate for an adviser to make blanket recommendations in any security, especially low-priced speculative securities. No matter what type of investment is involved, a blanket recommendation to a large group of people will always be wrong for some investors. Different investors have different objectives, and the same recommendation will not be suitable for every investor.

Legislative Risk

Legislative risk is the risk that the government will do something that adversely affects an investment. For example, beer manufacturers probably did not fare too well when the government enacted Prohibition.

Liquidity Risk

Liquidity risk is the risk that an investor will not be able to liquidate an investment when needed or that the investor will not be able to liquidate the investment without adversely affecting its price.

Long-term liabilities include: Bonds. Mortgages. Notes.

Long-term liabilities are debts that will become due after 12 months.

Churning In addition to churning where the agent or firm executes too many transactions to increase revenue, a practice known as reverse churning is also a violation. Reverse churning is the practice of placing inactive accounts or accounts that do not trade frequently into fee-based programs that charge an annual fee based on the assets in the account. This fee covers all advice and execution charges. Since these inactive accounts do not trade frequently, it will cause the total fees charged to the account to increase and makes a fee-based account unsuitable for inactive accounts and for accounts that simply buy and hold securities for a long period of time. These accounts will generally be charged an annual fee in the range of 1-2% of the total value of the assets in lieu of commissions when orders are executed.

Many advisers are compensated when a customer makes a transaction based on their recommendation. Churning is the practice of making transactions that are excessive in size or frequency, with the intention of generating higher commissions. When determining if an account has been churned, regulators will look at the frequency of the transactions, the size of the transactions, and the amount of commission earned by the representative. Customer profitability is not an issue when determining if an account has been churned.

Income Some investments that will help to meet that objective are: Corporate bonds. Municipal bonds. Government bonds. Preferred stocks. Money market funds. Bond funds. Bond ladder

Many investors are looking to have their investments generate additional income to help meet their monthly expenses.

Market Risk

Market risk is also known as a systematic risk; it is the risk that is inherent in any investment in the markets. For example, you could own stock in the greatest company in the world and you could still lose money because the value of your stock is going down, simply because the market as a whole is going down.

Expected Return Investments with higher standard deviations contain more risk than investments with lower standard deviations. As an investment's results are plotted over time, there is a 95% chance that its actual return will be within two standard deviations of its expected return and a 67% chance that it will be within one standard deviation of its expected return. Portfolio managers will use computer simulations to examine the possibilities of various portfolio strategies. The Monte Carlo simulation is one such simulation used by portfolio managers.

Modern portfolio managers try to manage risk and evaluate investments by employing a variety of concepts under modern portfolio theory. Modern portfolio theory states that the expected rate of return for an investment is the sum of its weighted returns. An investment's weighted return is its possible return multiplied by the likelihood of that return being realized.

Guarantees

No representative, broker dealer, or investment adviser may make any guarantees of any kind. A profit may not be guaranteed, and a promise of no loss may not be made.

Nonsystematic Risk

Nonsystematic risk is the risk that pertains to one company or industry. For example, the problems that the tobacco industry faced a few years ago would not have affected a computer company.

Annualized Return EXAMPLE: SIA common stock appreciated 8% over an 18-month period and paid a 2% cash dividend over the 18 months. The total return in the this case would be 10%, found by adding the 2% in cash flow to the 8% appreciation. The holding period return would be 10% over the 18 months during which the investment was held. The annualized return would be 6.66%, found by dividing the 10% return by 1.5 as 18 months equals 1.5 years.10 / 1.5 = 6.66

Once the holding period return has been calculated it can then be used to determine the annualized rate of return. An investment's annualized rate of return will allow investors to compare the investment's return against the performance of relevant benchmarks. If a security was held for less than 1 year, its results would have to be multiplied to determine an annualized rate of return. If the holding period was more than 1 year, the results would have to be divided to determine the annualized rate of return.

Other assets include: Goodwill. Trademarks. Patents. Contract rights.

Other assets are intangible assets that belong to the company.

Preservation of Capital Investment choices that will achieve this include: Money market funds. Government bonds. Municipal bonds. High grade corporate bonds.

People who have preservation of capital as an investment objective are very conservative investors and are more concerned with keeping the money they have saved. For these investors, high-quality debt will be an appropriate recommendation.

Developing the Client Profile You should always ask questions like: How long have you been making these types of investments? Do you have any major expenses coming up? How long do you usually hold investments? How much risk do you normally take? What tax bracket are you in? How much money do you have invested in the market? Have you done any retirement planning? How old are you? Are you married? Do you have any children? How long have you been employed at your current job? Advisers, who help people invest to meet a specific objective, must make sure that their recommendations meet that client's objective. Should a person have a primary and a secondary objective, an adviser must make sure that the recommendation meets the investor's primary objective first and the secondary objective second. When developing the client's profile, advisers should also calculate the client's: Assets. Liabilities. Net worth. Monthly discretionary cash flow or income.

Recommendations to an advisory client must be suitable based on the client's investment objective and client profile. The adviser should obtain enough information about the customer to ensure that the recommendations are suitable based on a review of the client's: Investment objectives. Financial status. Income. Investment holdings. Retirement needs. College and other major expenses. Tax bracket. Attitude toward investing. The more you know about a client's financial position, the better you will be able help the client meet his or her objectives.

Risk vs. Reward Many types of risks are involved when investing money, including: Capital risk. Market risk. Nonsystematic risk. Legislative risk. Timing risk. Credit risk. Reinvestment risk. Call risk. Liquidity risk.

Risk is the reciprocal of reward. An investor must be offered a higher rate of return for each unit of additional risk the investor is willing to assume.

Selling Dividends If the investor purchased the shares just prior to the ex dividend date simply to receive the dividend, the investor in many cases would end up worse off. The dividend in this case would actually be a return of the money that the investor used to purchase the stock, and then the investor would have a tax liability upon receipt of the dividend.

Selling dividends is a violation that occurs when advisers use a pending dividend payment as the sole basis of their recommendation to purchase a stock or mutual fund. Additionally, using the pending dividend as a means to create urgency on the part of the investor to purchase the stock is a prime example of this type of violation.

Beta measures systematic risk in the price volatility of a security relative to the market as a whole

Standard deviation measures both systematic and unsystematic risk in the volatility of the return of a security versus its expected return

Capital stock at par: The aggregate par for both common and preferred stock. Additional paid in surplus: Any sum paid over par by investors when the shares were issued by the company. Retained earnings: Profits that have been kept by the corporation, sometimes called earned surplus.

Stockholders' equity is the net worth of the company. Stockholders' equity is broken up into the following categories:

Tax Structure Regressive taxes level the same tax rate on everyone, regardless of their income. As a result, a larger portion of the lower income earner's earnings will go toward the tax. Examples of regressive taxes are: Sales taxes. Property taxes. Gasoline taxes. Excise taxes.

Taxes may be progressive or regressive. A progressive tax levies a larger tax on higher income earners. Examples of progressive taxes are: Income taxes. Estate taxes.

THE RULE OF 72 EXAMPLE: An investor who has $10,000 invested at an annual rate of 8% would like to know when the value of the account will reach $20,000. The answer is found by simply dividing 72 by the interest rate of 8%, as follows: 72 / 8 = 9 years The rule of 72 can also be used to calculate the rate of return on an investment given an initial value and a current value over time. If an investor placed $10,000 in an account 12 years ago and the value of that account has grown to $40,000, the value has doubled twice. The compound rate of return can be found by dividing 72 by the amount of time it took for the account to double once. Since the account doubled twice in 12 years, it therefore doubled once in 6 years. 72 / 6 = 12%

The Rule of 72 will tell an investor how many years it will take for the principal of an account to double in value. The rule of 72 assumes that the interest or earnings of the account are compounded. An investor who knows the interest rate that will be earned can simply divide 72 by that number to determine how long it will take the principal to double.

Sharpe ratio = (R - RFR)/SD The degree to which a portfolio's performance is designed to mirror the return of a standard benchmark or index is measured by R-squared. If the portfolio has 100% of its assets tied to an index, such as in an index fund, the portfolio will have an R-squared value of 100, and the performance of the portfolio will mirror the performance of the index. The higher the R-squared value for the portfolio, the higher the degree of correlation to the index. R-squared values range from 0-100, with the lower values having lower correlation to the index. A portfolio with a higher R-squared value will have a more accurate beta coefficient, and as a result the volatility of the portfolio will be more predictable.

The Sharpe ratio can measure a portfolio's risk-adjusted return. If two portfolios both return 8%, but portfolio A contains dramatically more risk than portfolio B, then portfolio B is a much better investment choice. The Sharpe ratio tells investors how well they are being compensated for the investment risk they are assuming. The Sharpe ratio takes the portfolio's return (R) and subtracts the risk-free return (RFR) offered on short-term Treasury bills (usually 90 days) to determine the level of return that the investor earned over the risk-free return. The risk premium is then divided by the portfolio's standard deviation (SD). Series 66 candidates will have to be able to identify the Sharpe ratio but most likely will not be required to calculate it.

The Uniform Prudent Investors Act of 1994 Those changes are: The main consideration of a fiduciary is the management and trade off between risk and reward. The standard of prudence for each investment will be viewed in relationship to the overall portfolio rather than as a stand-alone investment. -The rules regarding diversification have become part of the definition of prudent investing. -The restrictions from investing in various types of investments have been removed, and the trustee may invest in anything that is appropriate in light of the objectives of the trust and in line with other requirements of prudent investing. -The rules against delegating the duties of the trustee have been removed and the trustee may now delegate investment functions subject to safeguards.

The Uniform Prudent Investors Act of 1994 (UPIA) sets the basic standards by which all investment professionals acting in a fiduciary capacity must abide. The UPIA updates the requirements and definitions of prudent standards in light of the application of modern portfolio theory and the advancement in the understanding of the behavior of capital markets. The UPIA laid out five fundamental changes in the approach to prudent investing for investment professionals acting in a fiduciary capacity.

Current assets include: Money market instruments. Marketable securities. Accounts receivable net of any delinquent accounts. Inventory, including work in progress. Prepaid expenses.

The assets are listed in order of liquidity. Current assets include cash and assets that can be converted into cash within 12 months.

The Balance Sheet The basic balance sheet equation is: assets - liabilities = net worth The balance sheet equation may also be presented as: assets = liabilities + shareholder's equity The two columns on the balance sheet contain the company's assets on the left and its liabilities and shareholders' equity on the right. The total dollar amount of both sides must be equal, or balance.

The balance sheet will show an investor everything that the corporation owns, or its assets, and everything that the corporation owes, or its liabilities, at the time the balance sheet was prepared. A balance sheet is a snapshot of the company's financial health on the day it was created. The difference between the corporation's assets and its liabilities is its net worth. The corporation's net worth is the shareholders' equity. Remember that the shareholders own the corporation.

Capital Asset Pricing Model (CAPM) Proponents of CAPM have developed the capital market line or CML to evaluate and measure the expected returns of a diversified portfolio relative to the expected returns of the market and the expected risk-free return. The CML also measures the standard deviation of the portfolio relative to the standard deviation of the market. A further derivative measure known as the security market line or SML is used to measure the expected return of a single security based on its beta relative to the expectations of the market and risk-free rate of return. The CML is not based on alpha or beta, while the SML is partially computed based on the beta of the single security in question.

The capital asset pricing model (CAPM) operates under the assumption that investors are risk averse. Investors who take on risk through the purchase of an investment must be compensated for that risk through a higher expected rate of return known as the risk premium. A security's risk is measured by its beta. Therefore, securities with higher betas must offer investors a higher expected return in order for the investor to be compensated for taking on the additional risk associated with that investment.

Efficient Market Theory Weak-form efficiency: States that the future price of a security cannot be predicted by studying the past price performance of the security. This form of the theory believes that technical analysis cannot produce excess returns. Semi-strong form efficiency: States that the market price of a security adjusts too rapidly to newly available information to achieve an excess return by trading on that information. Strong-form efficiency: States that the current price of a security reflects all information known and unknown to the public and that there is no opportunity to earn excess returns.

The efficient market theory believes that all of the available information is priced into the market at any given time and that it is impossible to beat the market by taking advantage of price or time inefficiencies. Proponents of the efficient market theory may follow the theory in the following ways:

Trading ahead

The entering of an order for a security based on the prior knowledge of a soon to be released research report.

Front running

The entering of an order for the account of an agent or firm prior to the entering of a large customer order. The firm or agent is using the customer's order to profit on the order it has entered for its own account.

Professional Conduct by Investment Advisers Violations of state and federal laws may result in fines, expulsion from the state or industry, or a jail term. Investment advisers are expected to adhere to all of the rules and regulations set forth in the Investment Advisers Act of 1940, as well as all state and federal laws.

The fiduciary duty of an investment adviser goes beyond that of a broker dealer. The investment adviser is required to develop a client profile when opening the client's account and must update it regularly as the client's needs change. Investment advisers have a fiduciary duty to provide only suitable advice to clients.

Holding Period Return The total return from any cash flow plus or minus any capital appreciation or depreciation realized during the time the investment was held equals the holding period return.

The holding period for a security may be very long or very short depending on the investor. Some investors hold securities for years while others may only hold securities for a few days or less.

Internal Rate of Return Like an NPV calculation, it is a discounted cash flow method used to determine the merits of an income-producing investment. The IRR is the rate that would make the discounted present value of future cash flows equal to the current market price of the investment.

The internal rate of return (IRR) is the annualized average return expected during the life or holding period of an investment.

Current liabilities include: Wages payable, including salaries and commissions owed to employees. Accounts payable to vendors and suppliers. Current portion of long-term debt; that is, any portion of the company's long-term debt due within 12 months. Taxes due within 12 months. Short-term notes due within 12 months.

The liabilities of the corporation are listed in the order in which they become due. Current liabilities are obligations that must be paid within 12 months.

Capitalization

The term capitalization refers to the sources and makeup of the company's financial picture. The following are used to determine the company's capitalization: Long-term debt Equity accounts, including par value of common and preferred and paid in and earned surplus A company that borrows a large portion of its capital though the issuance of bonds is said to be highly leveraged. Raising money through the sale of common stock is considered to be a more conservative method for a corporation to raise money because it does not require the corporation to pay the money back. When a company borrows funds, it is trying to use that borrowed capital to increase its return on equity.

Limited partnerships, LLCs, and S corporations provide asset protection and avoid double taxation by distributing income and losses to the owners or members.

The ultimate selection of the business structure largely depends on the needs of the person and the type of business that is being conducted. Specific consideration should be given to the tax implications, ease of establishment, and asset protection. LLCs have become popular choices for smaller businesses as they allow for the flow through of taxes, are easily established, and provide the asset protection of a corporation. A C corporation would be the most suited for a business that needed to raise a substantial amount of capital or was projected to be very profitable.

Estate Taxes Certain items will be added to the individual's gross estate, including: Assets transferred within 3 years of death. Annuity payouts payable to the estate or heirs. Life insurance. The following are deducted from the value of the estate: Debts owed by the individual or estate Funeral expenses Charitable gifts made after death Assets that are left to relatives more remote than children, for example, grandchildren, may be subject to a special tax if the amount exceeds $1,000,000. This is known as generation skipping.

The value of an estate that may be left to heirs (nonspouse) without subjecting the beneficiaries to estate taxes has been constantly changing. There is an unlimited marital deduction or unified credit that allows surviving spouses to inherit the entire estate tax free. An individual's gross estate includes all of the assets owned at the time of death, including assets placed in any revocable trusts. Assets placed in an irrevocable trust are excluded from the individual's estate.

Timing Risk

Timing risk is simply the risk that an investor will buy and sell at the wrong time and will lose money as a result.

Total Return If the security has fallen in value, the total of the cash flow may partially or totally offset the loss of value of the security in question.

To determine the total return of an investment, all dividend or interest cash flow must be taken into consideration. If the investment has increased in value, the sum of the cash flow is added to any capital appreciation. The addition of the cash flow will cause the total return to be higher.

Trusts While most trusts are established during a person's lifetime (known as an inter vivos trust) a trust may also be established to hold or to distribute assets after a person's death under the terms of their will. Trusts that are established under the terms of a will are known as testamentary trusts. All assets placed into a testamentary trust are subject to both estate taxes and probate. Trusts can be established to both protect assets from legal claims as well as for estate tax planning purposes. A bypass trust is one that is established to reduce the tax liability of an estate left to beneficiaries other than a spouse, such as to children. The bypass trust allows the grantor to take advantage of the lifetime estate tax exclusion and allows individuals with significant wealth to reduce the tax burden to their heirs. A generational skipping trust is a type of bypass trust that is established for the benefit of relatives more distant than one generation from the grantor such as grand children or great grandchildren. This type of bypass trust will allow assets to be passed on to grandchildren without first being passed to their parents and without potentially being taxed again upon their parents death. Assets left to grandchildren or unrelated persons more than 37.5 years younger than the grantor may be subject to a generation skipping transfer tax (GSTT).

Trusts may be revocable or irrevocable. With a revocable trust, the individual who established the trust and contributes assets to the trust, known as the grantor or settlor, may, as the name suggests, revoke the trust and take the assets back. The income generated by a revocable trust is generally taxed as income to the grantor. If the trust is irrevocable, the grantor may not revoke the trust and take the assets back. With an irrevocable trust, the trust usually pays the taxes as its own entity or the beneficiaries of the trust are taxed on the income they receive. If the trust is established as a simple trust all income generated by the trust must be distributed to the beneficiaries in the year the income is earned. If the trust is established as a complex trust the trust may retain some or all of the income earned and the trust will pay taxes on the income that is not distributed to the beneficiaries. The grantor of an irrevocable trust is generally not taxed on the income generated by the trust unless the assets in the trust are held for the benefit of the grantor, the grantor's spouse, or if the grantor has an interest in the income of the trust of greater than 5%.

Taxes on Foreign Securities In the event that the foreign country withholds taxes, the investor may file for a credit with the IRS at tax time. Most foreign governments that withhold taxes will withhold 15%.

U.S. investors who own securities issued in a foreign country will owe U.S. taxes on any gains or income realized.

Types of Advisory Clients Clients may hold investments in their own name or in any of the following entities: A sole proprietorship A C corporation An S corporation A partnership A limited partnership A family limited partnership A trust

When an adviser meets with a potential new client, the adviser must determine the legal structure under which the client operates.

Gift Taxes Individuals may give gifts of up to $16,000 per person per year without incurring any tax liability. If a gift in excess of $16,000 is given to an individual, the donor owes the gift tax. Gifts to charity are always tax free, as is paying someone's educational expenses or medical expenses.

When gifts are made to family members or others individuals, the donor does not receive any tax deduction. The donor's cost base will transfer to the recipient for tax purposes.

Reinvestment Risk

When interest rates decline and higher yielding bonds have been called or have matured, investors will not be able to receive the same return given the same amount of risk. This is called reinvestment risk, and the investor is forced to either accept the lower rate or take more risk to obtain the same rate.

Periodic Payment Plans -A statement that a profit is not guaranteed. -A statement that investors are not protected from a loss. -A statement that the plan involves continuous investments, regardless of market conditions.

When recommending or advertising a periodic payment plan, the following must be disclosed:

Sole proprietorships

are easily established to allow a person to conduct business under a trade name. For all intents and purposes the sole proprietorship is an extension of the proprietor. All taxes are reported on the individual's return and there is no asset protection.