CHAPTER 10 INVESTMENT BASICS

LEARNING OBJECTIVES

After completing this chapter, you should be able to do the following:

  Apply the three phases in the investment planning process.

  Identify what is considered a security under the Securities Act of 1933.

  Differentiate among the various business models and compensation methods used for investment planning.

  Analyze methods used to assess a client’s risk tolerance.

Introduction

Investment planning, more than any other area within the discipline of personal financial planning, is the service most familiar to consumers. It is also the area with the greatest professional and regulatory oversight. In order to understand the basics of investment planning, a review of the regulatory landscape and the various ways in which investment planning services are provided to consumers is essential.

Securities Defined

Any discussion of investment planning has to start with securities. Perhaps the greatest surprise to first-time practitioners regarding investment planning is the sheer scope of what is considered a security. For purposes of PFP, a security is more than a publicly held stock or bond that is traded on a national securities exchange like the New York Stock Exchange or NASDAQ. And in point of fact, under both federal and state securities laws, a security is very broadly defined. The Securities Act of 1933 defines a security as:

Any note, stock, treasury stock, security future, security-based swap, bond, debenture, evidence of indebtedness, certificate of interest or participation in any profit-sharing agreement, collateral-trust certificate, preorganization certificate or subscription, transferable share, investment contract, voting-trust certificate, certificate of deposit for a security, fractional undivided interest in oil, gas, or other mineral rights, any put, call, straddle, option, or privilege on any security, certificate of deposit, or group or index of securities (including any interest therein or based on the value thereof), or any put, call, straddle, option, or privilege entered into on a national securities exchange relating to foreign currency, or, in general, any interest or instrument commonly known as a “security”, or any certificate of interest or participation in, temporary or interim certificate for, receipt for, guarantee, warrant or right to subscribe to or purchase, any of the foregoing.¹

Dealing with this rather wide array of financial instruments, all known as securities, takes a great deal of knowledge and careful consideration. That, in effect, is what investment planning is.

The Role of the Personal Financial Planner and Compensation

So what role do personal financial planners play in working with securities and providing investment planning? Recall from chapter 2 that the AICPA Statement on Standards in Personal Financial Planning Services (SSPFPS) No. 1 states

PFP is the process of identifying personal financial goals and resources, designing financial strategies, and making personalized recommendations (Ref: par. 12) (whether written or oral) that, when implemented, assist the client in achieving these goals. This process may include implementation of recommendations or monitoring or updating the engagement.²

The activity of investment planning is a PFP service. Most consumers do not perceive a distinction between an investment adviser and a personal financial planner. To the public, these terms are synonymous for an individual who provides advice regarding investments. This captures an important issue, in that there is no specific, direct regulation of personal financial planners at the federal or state level. However, there are laws and regulations that apply to investment services provided by personal financial planners.

EXAMPLE

The investment services provided by individuals who hold themselves out as personal financial planners are primarily regulated by the Securities and Exchange Commission (SEC) and individual states. When acting in this capacity, the individuals are referred to as investment adviser representatives (IARs). Additionally, if the personal financial planner sells insurance products, or receives commissions for the sale of securities, the planner is subject to laws and regulations governing insurance brokers and registered representatives—both discussed later in the chapter. A personal financial planner who is also a CPA is subject to SSPFPS No. 1, as follows:

The member should comply with applicable federal, state, and other laws and regulations. The member should comply with professional standards applicable to the PFP engagement unless superseded by laws or regulations. When there is a conflict between the statement and laws or regulations, the laws or regulations will prevail unless less stringent than the statement.³

Because investment planning is a business, there will always be some form of compensation involved. Compensation for investment planning is broadly defined. Compensation may be defined as a receipt of any economic benefit. In financial services, economic benefits come in all shapes and sizes: fees, commissions, tickets to sporting events, cruises, and production bonuses tied to annual production numbers and not to a specific client. Additionally, it is not necessary that the compensation be paid directly to the planner for it to be considered compensation. If the planner’s firm, or entities which the planner has a controlling interest in, receives an economic benefit, then it is deemed that the planner has received compensation for purposes of disclosure to a client.

Business Models

As we mentioned in the last section, investment planning is a business, and that business can take on different forms. The two main models through which investment planning is offered are the broker-dealer model and the registered investment adviser model. Let’s take a look at both.

BROKER-DEALER MODEL

A broker is any person or entity engaged in the business of effecting transactions in securities for the account of others. A dealer is any person or entity engaged in the business of buying and selling securities for his own account, through a broker or otherwise. A Broker-dealer provides both services and has an obligation to obtain the best execution of a securities transaction, which generally means achieving the lowest cost to the investor under the circumstances presented.

Broker-dealers (BDs) are regulated under the Securities Exchange Act of 1934 and are required to be members of the Securities Investor Protection Corporation (SIPC). SIPC oversees the liquidation of broker-dealers that close as a result of bankruptcy or financial difficulties. SIPC protects each investor for up to $500,000 for securities and cash (cash is limited to $250,000).

Broker-dealers often provide investment planning advice to their clients. However, because the investment planning advice is incidental to their brokerage activities, they are exempt from registering as registered investment advisers. A registered representative (RR) is licensed to sell securities for a broker-dealer—and for the sale of those securities, the RR receives a commission.

It is important to understand that the registered representative of a brokerdealer is not a fiduciary. When an RR offers investment planning services, the recommendations only have to be suitable for the investor. A suitability standard of care is a standard that is applicable to a wide variety of investors and not to a specific investor.

REGISTERED INVESTMENT ADVISER (RIA) MODEL

Registered investment advisers (RIAs) are regulated under the Investment Advisers Act of 1940. The RIA is an individual or a firm that is in the business of giving advice about securities. Examples of investment advisory services include recommending asset allocation or rebalancing; providing advice regarding the selection or retention of an investment manager; providing advice concerning securities, even if not related to specific securities; and providing general investment advice. The compensation received by RIAs is in the form of fees for providing advice on investing in securities such as stocks, bonds, mutual funds, or exchange traded funds. In addition, it is common for investment advisers to manage portfolios of securities. RIAs are paid in the following ways:

•A percentage of the value of the assets they manage

•An hourly fee

•A fixed fee

Unlike registered representatives of broker-dealers, registered investment advisers are held to the fiduciary standard. RIA activities are primarily overseen by the SEC or its counterparts at the state level, which have universally adopted the SEC’s positions. As shown in exhibit 10-1, the SEC has identified specific fiduciary duties that a registered investment adviser must provide to investment planning clients.

EXHIBIT 10-1	FIDUCIARY DUTIES

The list in exhibit 10-1 is illustrative of the duties an investment adviser must provide to a client. It is not meant to be all inclusive.

DUAL-LICENSE MODEL

Individuals and firms may be registered as both a broker-dealer and an RIA. These individuals and firms are referred to as either dually registered or hybrid advisers.

There are two primary ways of accomplishing dual registration. The first way is for broker-dealers to create their own wholly owned RIA. The second way is for independent RIAs to register as RRs of a broker-dealer. This dual registration allows for compensation to be paid in the form of commissions and fees. If the adviser is also licensed for insurance, there may be insurance commissions, as well.

Dual registration is difficult. It requires two sets of books and records. A single client will have a broker-dealer client file, subject to broker-dealer and FINRA inspections, and a separate file for investment advisory activity subject to the SEC and RIA review. It is critical that the investment client understand in which capacity the financial adviser is acting, either as a registered representative or as an investment adviser representative. There are separate practice standards for each registration, which is discussed next.

CPA DISCLOSURE REQUIREMENTS

In the PFP process, whether as a registered representative (RR) of a broker-dealer or as an investment adviser representative (IAR) of a registered investment adviser (RIA), the CPA acts in a fiduciary capacity. As such, prior to beginning the PFP engagement—and throughout the engagement as circumstances dictate—the CPA should disclose, in writing, all compensation the member, the member’s firm, or affiliates of the member will receive for services rendered as an IAR or for products sold as an RR. The disclosure should include the following:

•The method of compensation, including the impact of indirect compensation

•The amount of compensation

•The time period over which compensation will be received

•The compensation, including noncash benefits, received by the member for referrals to other providers

Additionally, if compensation alternatives are offered, the CPA should disclose the differences in these alternatives in writing.⁴

The Investment Planning Process

Regardless of the business model or compensation method used, how exactly does investment planning work? Simply put, investment planning is a process. The phases in the investment planning process mirror the steps in the PFP process. The initial phase is the planning phase. The assets involved in the recommendation, the client’s income and liquidity needs, and the desired retirement date all must be considered. Because the planning phase is so important, we will discuss it in depth in the next section.

The second phase in the investment planning process is the implementation phase. During this phase, securities may be purchased or sold and assets may be rebalanced. If the PFP makes a recommendation to buy or sell securities, the planner must be appropriately licensed, whether or not he or she is participating in the transaction. The implementation phase may be a standalone implementation engagement, or it may be part of a much broader PFP engagement.

Monitoring and updating make up the third phase of the investment planning process. A monitoring engagement involves the tracking and communicating of the client’s progress in achieving established investment planning goals. An updating engagement involves revising the client’s current investment plan and investment planning recommendations. Like the implementation phase of investment planning, monitoring and updating may be standalone engagements, or they may be part of a much broader PFP engagement.

PORTFOLIO REBALANCING

The Planning Phase

Why did we note that the planning phase is so important? It is here that the investment planner undertakes a process of deep discovery. In fact, this level of PFP mandates registration as an RIA because the process creates an analysis specific to the client and ideally results in the creation of an investment policy statement (IPS). An IPS is best described as a strategic guide to the planning and implementation of an investment plan and is a covenant between an IAR, the portfolio manager, and the client. The IPS outlines the client’s general investment goals and objectives and describes the strategies that the IAR should employ to meet these specific objectives. Data such as asset allocation, risk tolerance, and liquidity requirements are included in an IPS. Other elements found in an IPS include the following:

•Specific financial goals

•Narrative of present financial condition

•Investment time horizon

An example of an investment policy statement will be presented in chapter 18, “Applications in Investment Planning.”

DETERMINE AND PRIORITIZE CLIENT’S SPECIFIC FINANCIAL GOALS⁵

The IPS should document the client’s attitude toward investing, as well as address whether the client is an experienced or novice investor. If the client has previous investment experience, it should also address what prior investments the client has held, and for what length of time. In addition, the IPS should note whether the client prefers investing in real estate as opposed to individual securities and whether the client had a positive or negative experience with regard to prior investing experiences. The client’s reaction to the market and his or her own portfolio during the time period 2007–2009 should also be part of the IPS. All of these factors help define the client’s attitude toward investing.

Lastly, specific goals clients have for their investment portfolios should be determined and the following questions answered for each client: Is the client investing for children’s education, for retirement, or to make a major purchase such as a sailboat?

The investment planning goals need to be specific, measurable, achievable, relevant, and time-bound—the “SMART” mnemonic first coined by management consultant George T. Doran.⁶ The time horizon, as well as the specific dollar amounts needed at some future date, needs to be clearly stated.

EXAMPLE

CLIENT’S FINANCIAL CONDITION⁷

Of course, to determine the reach of a client’s goal, an IAR needs to know the client’s starting line. In conjunction with the client, the IAR should make every attempt to create a statement of financial position, as well as a personal spending plan.

ASSESSING RISK TOLERANCE

An IPS also needs to address risk tolerance. The client’s attitude toward risk should be assessed and made part of the IPS. The client may be indifferent toward risk or may be the type of investor who never checks investment statements and views market volatility as a nonevent. On the other hand, the client may be someone who seeks risk for the thrill of it—someone who likes to double down on investments and go for broke. The client may even be a self-described adrenaline junkie. Lastly, the client may be risk averse and all assets may be in cash and cash equivalents.

There are several methods to assess a client’s risk tolerance. No one method is mandated. Many personal financial planners determine their client’s risk tolerance through conversation. These planners are adamant that their knowledge and experience creates a better asset allocation model than the computerized tools that have been created to assess the client’s attitude toward risk.

A risk tolerance questionnaire is the norm for most personal financial planners. The typical questionnaire has between 5 and 10 questions. Basic questions address time horizon and basic knowledge of investments. Each of the questions generates a type of numeric score. The sum of the values is tabulated and a hypothetical asset allocation is proposed.

Another type of risk tolerance assessment tool is a psychometric test. These tests are extensive and usually require 30–40 minutes to complete. The client is measured against a demographic pool of respondents. The result is often an asset allocation model based on the efficient frontier and the client’s indifference curve. Both of these concepts are discussed in later chapters.

IDENTIFY UNIQUE NEEDS

The personal financial planner needs to be familiar with unique constraints that directly affect an IPS. Exhibit 10-2 shows some of these constraints.

EXHIBIT 10-2	CONSTRAINTS AFFECTING AN IPS

Divorce or legal separation affects an IPS in a variety of ways. The amount of emergency reserves required will double in value. The asset allocation, originally based on the blending of the two individuals, will need to be readdressed in order to determine the correct allocation for the newly single client.

Family health issues have a material impact on an IPS. Any unknowns about the progression of a disease are difficult to predict. Inflation for healthcare costs certainly exceeds the Consumer Price Index, but calculating this additional amount is challenging. In recent years, inflation for healthcare costs has exceeded the most aggressive scenarios. A reasoned conversation with the client is necessary in order to create some type of mutual accord.

Small-business owners present their own unique set of needs. Their use of credit to grow their businesses and to provide operating cash in the event of a cash flow shortfall is a risk to the investment plan. If the economy is in the midst of an economic downturn, then credit may become restricted. The investment portfolio may be down, as well. If funds are needed and credit is not available from lenders, then securities may have to be sold at a loss.

Concentrated stock positions create risk for an investment plan because a large portion of the investment portfolio is dependent on the volatility of a single stock. It is more likely than not that a single stock will underperform the market. Knowing this should be reason enough to seek more diversification within your portfolio. A concentrated stock position exposes the client to lower liquidity and higher risk than ownership of a diversified investment portfolio.

Working with older clients in the investment planning process is challenging. The personal financial planner’s role is often expanded beyond the traditional investment planning engagement. Often, the planner becomes a proxy for absent family members. As a fiduciary, the adviser needs to be vigilant against potential elder fraud, financial abuse, and exploitation.

Clients with special needs not only require investment planning, but their investment plan requires coordination with government programs. In order to qualify for government benefits (for example, Section 8 housing) and subsidies, a special needs client’s investment portfolio must be held in a trust or have restrictions regarding the amount of income the portfolio is permitted to generate.

IDENTIFY POTENTIAL CLIENT INVESTMENT CONSTRAINTS

A number of factors can constrain a client’s investment decisions. An IAR has to take the time to understand what constraints might be present and how to adjust an investment plan accordingly. Three of the main constraints that arise deal with liquidity, time horizons, and human capital risk. Let’s take a closer look at these issues.

Liquidity⁸

Before a client begins an investment plan, emergency reserves should be established. This will assure adequate liquidity should any unexpected and unanticipated events occur—otherwise, investments may have to provide for short-term liquidity needs, which may result in undesired investment results. In addition, unplanned tax consequences could occur. By not having emergency reserves established, the agreed-upon time horizon is forfeited to meet an immediate need.

Time Horizon

The time horizon for the IPS is used to shape the asset allocation and select the securities to populate the asset classes. There are no mandated rules regarding time horizons; however, there are generally agreed-upon guidelines: short-term, intermediate, and long-term investment horizons.

A short-term investment horizon is typically five years or less. When an investor has a short-term time horizon, holding the investment in cash or cash equivalents is the most appropriate strategy. Money market funds and short-term certificates of deposit are popular conservative investments, as are savings accounts. Investing in these types of assets instead of stocks and bonds reduces risk and the potential for loss if a drop in the market were to occur during the short-term time horizon.

An intermediate investment horizon is 5 to 10 years. At this range, some exposure to stocks and bonds will help grow the initial investment’s value, and the amount of time until the money must be spent is far enough in the future to permit a degree of volatility. Balanced mutual funds, which include a mix of stocks and bonds, are popular investments for intermediate investment horizons.

Long-term investment horizons are those that are more than 10 years in the future. Some conservative investors may cite 15 years as the appropriate time horizon for long-term goals. Over long-term time periods, stocks offer the greatest potential rewards. Although they also entail greater risk, there is more time available to recover from any potential losses.

Human Capital Risks

Lastly, human capital risks are those risks unique to an investor’s ability to work, or to the investor’s susceptibility to premature death or disability. An investor’s ability to work and receive salary or income, which in turn is invested, should be addressed in the IPS. The client’s employer and the position the client holds with the employer should be documented in the IPS. Additionally, the viability of the client’s employer, as well as the risk of the elimination of the client’s position with the employer, should be evaluated. If a pension benefit is being relied upon, this should be noted as well. Morbidity (disability due to injury or illness) and mortality (premature death) also need to be addressed in the IPS. Documentation regarding sufficient insurance to address the risk of economic loss should be included. If there is none, investment assets will have to be utilized to address the economic loss and may affect how certain assets are invested.

Chapter Review

Planning for investments is not for the faint of heart. Personal financial planners managing or selling securities are overseen by a host of regulatory agencies. In addition, what constitutes a security is so broadly defined that a security may be almost any item of value which is purchased or sold. CPAs who plan to offer personal financial planning services have additional disclosure requirements over and above planners who are not CPAs.

The process of investment planning is equally as daunting as registration. An IPS—which is essentially a narrative of the client’s current financial condition, investment goals, and constraints—has to be written. The IPS has to take into account the client’s personal financial plan and should be drafted in a way that supports the plan.

CASE STUDY REVISITED

The appropriate advice for Virginia and Joseph Plant is to help them establish an investment plan, which they now agree they need. An IPS will need to be created.

Some of the issues you, as their personal financial planner, will need to address in order to complete the IPS include the following:

•Determine and prioritize the Plants’ specific financial goals.

•Create a statement of financial position and a personal spending plan.

•Discuss the recent inheritance. How well are they handling this newfound wealth?

•How will the required minimum distributions from the inherited IRA be addressed?

•Is there debt on the Lake Shore condo and are there condominium fees?

•Based on their spending plan, are the Plants able to afford the condominium?

•Is age 62 a realistic goal for financial independence?

•Will there be issues with Joseph continuing to work and drawing Social Security benefits prior to his full retirement age?

ASSIGNMENT MATERIAL

REVIEW QUESTIONS

1. Investment portfolio rebalancing is part of which phase in the investment planning process?

I. Planning.

II. Implementation.

III. Monitoring.

IV. Updating.

A. I.

B. I, II.

C. III.

D. II, IV.

2. When there is a conflict between Statement on Standards in Personal Financial Planning Services No. 1 and laws or regulations, the laws or regulations will prevail unless they _________ the statement.

A. Are equally as stringent as.

B. Are less stringent than.

C. Are more stringent than.

D. Contradict.

3. Which of the following is a security?

I. Bond.

II. LLC membership interest.

III. Mortgage.

IV. Stock.

A. I, IV.

B. I, III, IV.

C. IV.

D. I, II, III, IV.

4. A(n) _____ is licensed to sell securities for a broker-dealer and receives a ____ for the sale.

A. Investment adviser representative, commission.

B. Investment adviser representative, fee.

C. Registered representative, commission.

D. Registered representative, fee.

5. In a PFP engagement, the planner should disclose in writing all compensation that the member, the member’s firm, or affiliates of the member will receive for services rendered (IAR) or products sold (RR). The disclosure should include which of the following?

I. Amount of compensation.

II. Only cash benefits.

III. Only direct compensation.

IV. Time period over which compensation will be received.

A. I, III.

B. II, III.

C. I, IV.

D. II, IV.

6. Which of the following is not appropriate for a short-term investment horizon?

A. Certificates of deposit with maturities of 60 months or less.

B. Money market demand account.

C. Money market mutual fund.

D. Treasury bond.

7. Investment planning goals need to be specific, measurable, achievable, relevant, and ____.

A. Accountable.

B. Conservative.

C. Optimistic.

D. Time-bound.

8. Which of the following is not a method of assessing a client’s risk tolerance?

A. Conversation.

B. Psychometric test.

C. Risk tolerance questionnaire.

D. Tabulated test.

9. Which of the following is not a human capital risk?

A. Employment.

B. Medical expenses.

C. Morbidity.

D. Pension entitlement.

10. SIPC protects each investor for up to ____ for securities and cash (cash is limited to ____).

A. $100,000, $100,000.

B. $250,000, $250,000.

C. $500,000, $250,000.

D. $750,000, $250,000.

INTERNET RESEARCH ASSIGNMENTS

1. Download “Regulatory Coverage Generally Exists for Financial Planners, but Consumer Protection Issues Remain” (January 2011), a report from the U.S. Government Accountability Office (GAO). What are the key findings?

2. What tools and resources are available to investors at the Financial Industry Regulatory Authority’s (FINRA) website?

3. What tools and resources are available to investors at the Securities and Exchange Commission’s (SEC) website?

4. Download The CPA’s Guide to Investment Advisory Business Models (2015). What persons are excluded from the definition of investment adviser?

5. What is included in a customer’s investment profile under FINRA’s Rule 2111 (Suitability)?

6. Find an online risk tolerance questionnaire and assess your attitude toward investment risk. Do you agree with the tools assessment?

Notes