• If aggressive growth is the client's objective, he is looking for high-risk investments with the potential for very large returns. This is rarely the goal for an entire portfolio, but rather for a specific portion of assets. Aggressive growth funds and small-cap issues would be suitable for him.


FINRA CONDUCT RULE 2111

This rule pertains to suitable recommendations for clients and what registered representatives must take into account. This rule just reiterates that a client's financial status, tax status, investment objectives, and other relevant factors must be considered prior to making recommendations. It also requires the representative to deal fairly with customers. Representatives are in violation of FINRA's Conduct Rule 2111 if they do any of the following:

• recommend speculative low-priced securities without attempting to learn of his financial situation, needs, and other assets
• borrow or use a client's funds or securities
• fail to disclose important facts and risks about the security to each client
• make excessively-sized trades in a client's account
• recommend trades that are too expensive, too risky, or beyond the client's financial ability
• make trades too frequently in a client's account ("churning")
• participate in fraud (i.e. make unauthorized transactions in a customers account; set up fictitious accounts to disguise prohibited activities)

TYPES OF INVESTMENT RISKS

Interest Rate Risk

Interest rate risk is the possibility that a fixed-rate debt instrument will decline in value due to a rise in interest rates. Whenever an investor buys a security that offers a fixed rate of return, he exposes himself to interest rate risk. This is true for bonds and preferred stocks.

Business Risk

Business risk is the possibility that a company will have lower-than-anticipated profits, or that the company will experience a loss rather than taking a profit. Business risk is influenced by a number of factors, such as sales volume, per-unit price, input costs, competition, the economic climate, and government regulations. Not only is the company exposed to business risk, but it is also exposed to other various types of risk (financial, liquidity, systematic, currency exchange rate risk, etc). Since companies are exposed to a variety of risks, it is extremely important for it to minimize business risk. This can be achieved through diversification, which is simply spreading out investments (not putting "all eggs in one basket").

Credit Risk

Credit risk refers to the possibility that a borrower may not repay a loan, and that the lender may lose the principal of the loan or the interest associated with it.

Credit risk rises because borrowers expect to use future cash flows to pay current debts, but it's never possible to ensure that borrowers will definitely have the funds to repay their debts. The lender or investor is rewarded with interest payments for assuming the credit risk. These are the interest payments from the borrower or issuer. The higher the credit risk, the higher the interest rate on the bond.

Taxability Risk

This refers to the risk that a security that was issued with a tax-exempt status could potentially lose that status before maturity. Since municipal bonds carry a lower interest rate than fully taxable bonds, bondholders would end up with a lower "after-tax" yield than originally planned. This type of risk applies to municipal bond offerings.

Call Risk

Call risk is specific to bond issues. It refers to the possibility that a bond will be called (redeemed) prior to maturity. Call risk usually goes hand-in-hand with reinvestment risk because the bondholder must now find an investment that provides the same level of income at an equal amount of risk. Call risk is most prevalent when interest rates are falling (companies trying to save money will usually redeem bonds with higher coupon rates and replace them on the market with bonds with lower interest rates). In a declining interest rate environment, the investor is usually forced to take on more risk in order to replace his previous income stream.

Inflationary Risk

Inflationary risk is the chance that the cash flows from an investment won't be worth as much in the future due to inflation. In other words, the purchasing power of cash flow from an investment declines. Inflationary risk is also known as purchasing power risk. To fight this type of risk, a client should invest something appreciable with a growth component that stays ahead of inflation long-term. Stocks or convertible bonds are examples of appropriate investments.

Liquidity Risk

This is the risk that an investor will have difficulty selling an investment without incurring a loss. Selling real estate is a great example of this type of risk because it is usually fairly difficult to sell a piece of property at any given moment unless there is a high market demand for property! The opposite is true for government securities and blue chip stocks, as those are easy to sell at any given moment.

Market Risk

Market risk is the type of risk that will affect all securities in the same manner. In other words, it is caused by certain factors that cannot be controlled by diversification. Therefore, a representative should definitely keep this type of risk in mind when recommending mutual funds to clients. Mutual funds mainly appeal to investors because they offer a quick way to diversify their portfolios. The representative should always consider the type of diversification his client needs.

Reinvestment Risk

This is the risk that falling interest rates will lead to a decline in cash flow from an investment when its principal and interest payments are reinvested at lower rates. For instance, in a declining interest rate environment, a holder who has a bond that is either being called or nearing maturity is faced with the difficult task. He must invest the bond's proceeds in another bond of an equal or greater interest rate than the redeemed bond. Therefore, the holder is often forced to purchase a security that does not provide the same level of income, unless he takes on more credit risk or market risk and buys a bond with a lower credit rating.

Political Risk

Political risk is also referred to as social or legislative risk. This type of risk is associated with nationalization, unfavorable government actions, or social changes that result in a loss of value. Nationalization is the process of a government taking control of an industry. As this occurs, no compensation for the loss of potential income or loss of net worth of the seized assets is ever provided. Legislative risk is named as such because Congress has the power to change any laws affecting securities and consequently, some rulings result in adverse consequences.

Exchange Rate Risk

Exchange rate risk is also called currency risk. It refers to the financial risk that exists when a financial transaction is denominated in a currency other than the company's base currency. Investors with assets across national borders are exposed to currency risk (it creates unpredictable profits and losses). It can be reduced by hedging because it offsets currency fluctuations. The risk is also higher for short-term investments because there is not enough time for the currency values to "level off" (like they would for long-term investments).

MEASURING PORTFOLIO RISKS

An important concept to understand in this industry is risk versus reward. One of the concepts used in risk and return calculations is standard deviation, which measures the dispersion of actual returns around the expected return of an investment. The standard deviation is the square root of the variance. The variance is calculated by weighting each possible dispersion by its relative probability. In other words, take the difference between the actual return and the expected return, then square that number. This is another crucial concept to know. It is considered a basic measure of risk. If two potential investments had the same expected return, the one with the lower standard deviation would be considered to have less potential risk.

MEASURING RISK

Risk measures are statistical measures that are historical predictors of investment risk and volatility. The following are key risk measures used to predict volatility and rate of return:

• Alpha: This measures stock price volatility based on the specific characteristics of that particular security. The higher the number, the higher the risk.

•Sharpe ratio: This is a more complex measure that uses the standard deviation of a stock or portfolio to measure volatility. This calculation measures the incremental reward of assuming incremental risk. The larger the ratio, the greater the potential return.

                     Sharpe Ratio = (Total Return - Risk-free Rate of Return) / Standard Deviation of the Portfolio

•Beta: This measures stock price volatility based solely on general market movements. As a whole, the market is typically assigned a beta of 1.0. If a stock or portfolio is higher than 1.0, it is predicted to have higher risk and a potentially higher return. On the other hand, let's say that a stock or fund had a beta of 0.85. This would indicate that if the market increased by 10%, the stock or fund would probably only return 8.5%. However, if the market dropped 10%, the stock or fund would probably only drop 8.5%.

RISK TOLERANCE

Risk tolerance is the amount of risk a client is willing to assume. His financial status helps determine this amount too. The client's risk tolerance is the most important factor in choosing an asset allocation. Since risk tolerance might change over time, representatives should constantly re-visit this topic with their clients.

TIME HORIZON

All clients (should) have financial goals they want to reach by a certain time. The time horizon for each of the client's goals will affect asset allocation. A young investor has a long-term time horizon (regarding the need for investments) and can take on more risk. An older investor has a short-term time horizon (especially once the individual is retired) and has a low risk tolerance.

ASSET ALLOCATION

Asset allocation is an investment strategy that balances growth-oriented and income-oriented investments in a portfolio. This allows the investor to take advantage of the risk/reward trade-off, and benefit from both growth and income. The basic steps to asset allocation are as follows:

1. Choose which asset classes to include (stocks, bonds, money market, real estate, precious metals, etc.)
2. Select the ideal (target) percentage to allocate to each asset class
3. Identify an acceptable range within that target
4. Diversify within each asset class

Strategic asset allocation is a traditional portfolio strategy that involves setting target allocations for various asset classes, then yearly rebalancing the portfolio to maintain these original allocations. Rather than an active trading approach, this passive investment style is similar to a "buy and hold" strategy. Of course, the targets might change over time as the client's goals and needs change, and as the time horizon for major life events (college funding, retirement) grows shorter.

Tactical asset allocation (TAA) is a dynamic investment strategy that actively adjusts a portfolio's asset allocation. It is an active investment style. The goal of a TAA strategy is to improve the risk-adjusted returns of passive management investing. TAA allows for a range of percentages in each asset class (i.e. stocks = 40-50%). These are the minimum and maximum acceptable percentages that permit the investment adviser to take advantage of market conditions within these parameters. Therefore, a minor form of market timing is possible since the investor may move to the higher end of the range when stocks are expected to do better. He moves to the lower end when the economic outlook is bleak.

Once the target asset allocation percentages have been defined, diversification is the next step. Diversification helps reduce risk in a portfolio. Since different types of stocks have different characteristics, their rates of return will differ throughout the economic cycle. For example, let's say a portfolio is composed of 50% stocks the only investment is a large-cap stock fund. It might perform better during a downturn in the market than a small-cap fund would, but the small-cap fund might outperform the large-cap fund during a market rally.

Many investors choose to invest in individual stocks and mutual funds. There is a wide range of options available, and the information below applies only to individual stocks and mutual funds.

Market capitalization or market cap is the value of a company that is traded on the stock market. It is calculated by multiplying the total number of shares by the current market price of one of the shares. Stocks are classified by size. Examples are as follows:

•Large-cap stocks = $5 billion or more
•Mid-cap stocks = $1 billion to $5 billion
•Small-cap stocks = less than $1 billion
•Micro-cap stocks = less than $50 million

Diversifying across stocks with different market capitalization is recommended. A larger allocation should be made to large-cap stocks, and a smaller percentage should be dedicated to small-cap or mid-cap stocks.

Stocks and mutual funds are either growth-oriented or value-oriented.

A growth stock is a share in a company whose earnings are expected to grow at an above-average market rate. Growth stock yields little to no dividends and has a high price-to-earnings ratio. They tend to do well when the overall market is rising.

Value stocks are characterized by high dividend yields, low price-to-earnings ratios, and strong balance sheets. When a client invests in value stock, he is attempting to capitalize on inefficiencies in the market (since value stocks trade at a lower price than how the company’s performance might otherwise indicate). Therefore, it is considered to be undervalued. Value stocks tend to outperform growth stocks during a falling market.

INVESTMENT MANAGEMENT

There are two basic approaches to investment management-- active asset management and passive asset management.

Active asset management is based on a belief that a specific style of management or analysis can produce returns that beat the market. It seeks to take advantage of inefficiencies in the market and is typically accompanied by above-average costs. For those who favor an active management approach, stock selection is based on one of the following two styles:

Top-down: Managers who use this approach start by looking at the market as a whole and determine which industries and sectors are likely to do well given the current economic cycle. Then, they select specific stocks based on the companies that are likely to do the best within a particular industry.

Bottom-up: This approach ignores the market conditions and expected trends. Instead, a company is evaluated based on the strength of its financial statements, product pipeline, or other criteria. The idea is that strong companies are likely to do well, regardless of market or economic conditions.

Passive asset management is based on the idea that markets are efficient, returns cannot be surpassed regularly over time, and low-cost investments held long-term provide the best returns. Important passive management concepts are as follows:

The efficient market theory is based on the idea that the information that impacts the market (i.e. changes to company management, federal interest rate changes, etc) is instantly available and processed by all investors. As a result, this information is always taken into account in market prices. Those who believe in this theory believe that there is no way to consistently beat market averages.

Indexing is one way of taking advantage of the efficient market theory. As its name states, indexing is the process of using index funds (or creating a portfolio that mimics a particular index). Since index funds have below-average transaction costs and expense ratios, they can provide an edge over actively managed funds (which tend to have higher costs).

FACTORS RELATING TO SUITABILITY

Developing a financial profile on a client is the best way to determine which mutual fund recommendations would be suitable for him. Certain information must be collected at the beginning of a relationship with a client. It must also be updated any time the client's situation changes. The following information must be collected and used to build a client's profile:

• Type of client
• Current financial status
• Financial goals (capital and other needs)
• Current investments
• Non-financial considerations
• Risk tolerance

TYPES OF CLIENTS

In addition to individuals and married couples, there are many other potential client types. The goals of an organization are likely different from those of an individual. The following are potential types of clients:

Partnerships

•Business partnership -- all partners are equally responsible for business debts and share equally in business profits (which are reported on each partner's personal income tax return)
•Limited partnership -- the general partner manages the business and has unlimited liability for its debts; the limited partners are not responsible for any debt
•Family limited partnership -- primarily used as a means of minimizing estate and gift taxes but still must have a legitimate business purpose (i.e. managing investment real estate, family business, etc)

Corporations

The main advantage of all types of corporations is that the owners are not personally liable for the corporation's debts. The three types of corporations are as follows:

•C Corporation -- must pay corporate income taxes on their income; owners pay personal income taxes on profits received as dividends ("double taxation")

•S Corporation -- suitable for small companies (less than 75 shareholders) that want the legal protection of a corporation, but the flow-through taxation of a partnership; corporate losses are applied to personal income tax returns
•Limited Liability Corporation -- allows protection from debt but is taxed more like a sole proprietorship

CURRENT FINANCIAL STATUS

Before a representative can even begin to help a client meet his goals, he must first have a good grasp of the client's current financial situation. The representative must ask for the following information that relates to the client:

• Income
• Expenses
• Assets
• Liabilities
• Age, marital status, dependents
• Taxes/tax issues
• Participation in retirement and other benefit plans

FINANCIAL GOALS (CAPITAL AND OTHER NEEDS)

After acquiring this information, the client's specific goals should be discussed in detail. Nearly every client wants to plan for retirement and college for the children, but the representative must be sure to probe for other goals like starting a business, helping other family members, or buying a vacation home. A key consideration for any of these goals is the client's time horizon. This determines which type of investment strategy to use, and the amount of annual savings needed to reach the client's goals. Other needs must be discussed and planned for as well, such as the following:

•Emergency reserves: The standard amount a client should have in his emergency fund is three to six months of living expenses. The client might have other factors that dictate a larger or smaller need for liquid savings.

•Life insurance: If the client has a family whose income needs cannot be met through current assets, life insurance is needed. The total amount and type of insurance will depend on the client's particular circumstances.

CURRENT INVESTMENTS

Before making investment recommendations, it's important to understand the client's current investments ("holdings") and the strategies used to create them. The client might wish to liquidate some or all of these holdings and reinvest in a new portfolio, or he may want to retain all his current holdings.

RISK TOLERANCE

Risk tolerance is one of the primary things to consider when recommending investments to a client. A representative must be aware of how much risk a client is willing to take. For example, if a client is uncomfortable with the inherent risk of a growth portfolio or a specific investment option, his hesitance deems the investment as unsuitable (even if it matches the client's time horizon and financial goals)! A representative might try to educate a client on the different types of investments, their history of performance, and the "risk versus reward" trade-off. However, the client always has the final say in how much risk he wants to take. A client's risk tolerance regarding investment choices is influenced by the following:

• liquidity needs (short-term and long-term)
• inflation or deflation
• a change in income level
• his attitude towards risk

NON-FINANCIAL CONSIDERATIONS

Certain non-monetary issues might also affect which investments and strategies are appropriate for a client. Some examples are investor knowledge, investor sophistication, client values, and client demographics.

GENERAL INVESTMENT OBJECTIVES

Although a client's general investment objectives are not specific to his specific needs (i.e. retiring at a certain age, college plans for children), there is a correlation between those objectives and needs. The following describe a few investment objectives and suitable recommendations for the client:

• If preservation of capital is the client's objective, he is more concerned with safety than return. Treasury bills and money market funds would be the most appropriate investments for him.

• If current income is the objective, the client needs a portfolio that produces steady income for current living expenses. Bonds, annuities, and stocks with high dividends (i.e. utility stocks) would be the most appropriate investments for him.

• If tax-exempt income is the client's objective, he wants to shield his portfolio earnings from taxation as much as possible. Bonds would be suitable for the investor.

• If growth and income is the client's objective, he wants a portfolio that generates some amount of income but is also looking for capital appreciation (for protection against inflation). A mix of bonds and stocks would be suitable for him.

• If capital appreciation is the client's objective, his goal is to save for an event in the future (i.e. retirement). In other words, his goal is growth/he does not need any current income! A diversified stock or mutual fund portfolio would be appropriate for him.

• If aggressive growth is the client's objective, he is looking for high-risk investments with the potential for very large returns. This is rarely the goal for an entire portfolio, but rather for a specific portion of assets. Aggressive growth funds and small-cap issues would be suitable for him.


FINRA CONDUCT RULE 2111

This rule pertains to suitable recommendations for clients and what registered representatives must take into account. This rule just reiterates that a client's financial status, tax status, investment objectives, and other relevant factors must be considered prior to making recommendations. It also requires the representative to deal fairly with customers. Representatives are in violation of FINRA's Conduct Rule 2111 if they do any of the following:

• recommend speculative low-priced securities without attempting to learn of his financial situation, needs, and other assets
• borrow or use a client's funds or securities
• fail to disclose important facts and risks about the security to each client
• make excessively-sized trades in a client's account
• recommend trades that are too expensive, too risky, or beyond the client's financial ability
• make trades too frequently in a client's account ("churning")
• participate in fraud (i.e. make unauthorized transactions in a customers account; set up fictitious accounts to disguise prohibited activities)