2 - FINANCIAL PLANNING (fin) Flashcards
What is financial planning
- professional service for people who need objective assistance in org financial affairs to achieve financial and lifestyle goals
- covers areas including CF managements, retirement planning, investment/tax/estate planning - goal is to optimise allocation of financial resource to meet short and LT needs
- evolving plan of action
Financial + IM planning process
- collate all relevant info + consider vulnerability
- asses level of risk client is willing to undertake and understanding of risk
- determine feasibility or risk and return expectations + goals
- determine client ability to withstand loss/capacity for loss/level of comfort
- consider ethical/resp/sustainable views
- establish macro backdrop, risk + liqudiity
- other considerations
- review range of solutions and which most suitable
- direct or indirect strategy
- construct portfolio based on investment strat
- present recs to client with docs and risk warnings and how you came to solution
Client info to obtain in step on of planning process
Phases of FP Process
- Establishing client relationship
- identify needs of client + determine if firm is able to meet, if advisor has necessary competencies/skills
- explain services firm offers and outlines processes/reg disclosures
- determine if advice from other experts needs (Tax, lawyers etc)
- gaining/earning trust of client and devleop rapport, good listener - Collect client info
- advisor identifies client personal info, financial needs/objectives + priorities so they can analyse financial position and find suitable solutions
- clearly explain reason for collection is so firm can act in clients best interests
- Agreeing investment/financial objectives and any constraints
- Establishing risk profile
- Collecting quant and quali data needed
- KYC info
- risk profiling (ability, attitude, tolerance)
- liquidity reqs, time horizons, tax status, investment pref - Analyse client financial status
- assets and liabilities, commitments, inheritance, pensions, income etc
- net assets, CF statement, tax analysis and lifetime CF statements - Dev client solutions
- investment objectives and constraints taking into account ability and willingness to take risk
- ESG/responsible preferences
- ensure recommendations are affordable and if no suitable prod is available then no rec should be made - Implement
- Review
Trust in client relationships
Trust in technical competence
- experience and knowledge, help to make hard financial decisions
- explains clearly without jargon or oversimplifying
Trust in ethical conduct and character
- personal ethic of advisor and rep of firm
Trust in empathetic skills and maturity
- interpersonal relationships - death, discretion, empathy, tact, comfort
Client cats - elective professional client assessment
establish appropriate category @ outset and keep under review
Retail clients can request recategorization if they meet quali/quant reqs
- must be specified which prods/servs client wishes to be catergorised for
Quali test
- sufficient experience and understanding? assess expertise and knowledge, capable of understanding risks?
- client trading history, financial standing
Quant test (at least 2)
- has carried out trans in significant size on relevant market at avg freq of 10/q over last 4q
- financial instrument portfolio >500k euro
- has worked in financial sector for >1y in profesh position that reqs knowledge of transactions envisaged
Client must
- state in writing they want to be treated as proesh
- firm must state in writing the warnings of protections they lose
- client must state in writing separately they are happy with losses
Consequences of opting up to profesh categorisation
Comms
- may be more complex/detailed on trades etc
- info about firm itself may be less specific and less frequent
Suitability/Appropriateness
- firm assumes client has necessary level of experience and knowledge to understand risks when assessing suitability for professional client
(in relation to prods/servs they have been opted up for)
Dealing
- dealing location less restricted (must be RIE, MTF or systematic internaliser for retain)
- for XO trades, trimeframe is more rigorous for providing confirmation for retail clients
Funds
- unregulated CISs are deemed too risky and not suitable for retail investors but can be promoted to professional
Reporting
- For retail clients: have to inform client when value of leveraged instruments depreciate by >10% (and every 10% after) but dont have to do for profesh
Client assets
- client money rules more prescriptive for retail clients
- firms can transfer ownership of assets from client to firm as collateral to cover future or current obligations for professional clients but not retail
Retail clients cannot opt up another step to EC - but other profession clients can opt up to EC
Mifid client catergories
- Retail Clients
Definition: Everyday individuals or less experienced investors.
Protection: Highest level of protection.
Regulations: Firms must ensure best execution, appropriateness tests, and extensive disclosures.
Risk Awareness: Clients considered less experienced with financial products - Professional Clients
Definition: Institutional investors, large corporations, or individuals with significant financial knowledge.
Protection: Moderate level of protection.
Regulations: Some obligations like best execution apply; fewer disclosures required.
Risk Awareness: Clients are assumed to understand the risks of complex financial instruments. - Eligible Counterparties (ECPs)
Definition: Financial institutions, governments, large corporations, or supranational organizations.
Protection: Lowest level of protection.
Regulations: No best execution or appropriateness requirements; minimal disclosure needed.
Risk Awareness: Considered the most sophisticated clients, able to assess risks on their own.
Note: Clients can request to be “opted up” or “opted down” for higher or lower protection levels, depending on their experience and knowledge.
Independent vs restricted advice
Independent advice
- advisor is able to recommend product from the entire market and must consider all relevant options
- not biased or influenced by affiliations or llimitations
- duty to recommend best prod regardless of provider
Restricted
- advice provided that only offers prods from certain providers or limited range of products
- must disclose nature of restriction to client (where it is restricted, if product restrictions are entities with close links to firm)
FCA good practise ML checks
- use of electronic verification and PEP databases (understanding limitations)
- cater for customers who lack common forms of ID
- understands complex or opaque corporate structures
- source of weatlh = how customer/beneficial owner acquired total wealth
- source of funds = refers to origin of specific funds involved in bis relationship (salary, sale proceeds etc)
Responsibilities of fiduciary relationship between advisor and client
- act in utmost good faith
- not profit from trust placed in you
- not put in position where own interests conflict those of a client
- dont misuse confidential info for own advantage or for advantage of 3rd party
BF
Traditional finance theory suggests investors = rational decision makers in light of risk and return ops
In practise - emotion/psychology etc influence our decision making and cause us to act in irrational ways
BF looks at how psych influences investors and financial markets, focusing on how cognitive biases, emotions, and social factors affect financial decisions, often leading to irrational behaviour and market inefficiencies.
Heuristics
Mental shortcuts people use to make decisions in complex or uncertain environments
Reliance on heuristics increases when stressed (short on time/emotional/complex)
Can lead to systematic biases and errors in judgement
Bounded rationality = people seek to make decision that is good enough vs the best possible/most optimal decision
To prevent over reliance
- PM could limit to no. of portfolio options presented to client/ensure high qual and properly differentiated (to avoid choice overload)
- explain herd behaviour using precious asset bubbles
- take account of way info is presented to clients
BF: Use of information
- Indivs may not take into account all the relevant info
- Helps explain why investors rely on past perf and fail to take full account of risk/return characteristics
Investment inertia
Tendency of indivs to maintain current course of action - even when faced with new info/changes in environment that suggest changes should be made
- e.g. not changing portfolio AA
Tendency to stick with default option
- e.g. default pension fund
Causes:
Status Quo Bias: A preference for maintaining current decisions to avoid potential regret or loss, especially in complex situs
Cognitive Effort: Avoidance of the mental effort required to reevaluate and change investment positions.
Representativeness
Tendency to see patterns where they dont exist when having to make decisions under conditions of uncertainty w/ inadequate info
- tend to draw inferences without considering sample size + extrapolate beliefs from isolated occurrences (e.g. recession in covid vs 2024 = v diff causes)
- investors classify new information based on how closely it resembles existing stereotypes or patterns, rather than using statistical reasoning or objective analysis
-can lead to incorrect judgments about the likelihood or relevance of an event.
Key Issues:
assume similarity in one aspect will lead to similarity in others
e.g. making inv decisions on basis of value vs growth only vs detailed analysis of company’s distinct features
Can result in overreaction to short-term trends and poor decision-making based on faulty assumptions
Overconfidence
Tendency to have exaggerated views of own abilities/judgements
Can be linked to anchoring effect - especially when people asked to estimate range of possible values
- can lead to investors overestimating predictive ability
- constructing future forecasts that are too optimistic and UW prob of bad outcomes - can lead to more risk taking and overtrading
- analysts slow to revise previous assessments even where there is evidence it is incorrect
-w/ clients - can be hard to establish true risk profile when there is overconfidence
Anchoring
Tendency for indivs to fixate on arbitrary initial value/anchor as unconscious reference point when making decision
- then not being conscious of more info entering the market
- persists even when investor is aware that value is random
- not making decision based on fundamentals just considering purchase price relative to anchor value
Gambler’s fallacy
Failure to appreciate implications of randomness and probability
- belief that an event (whose occurrences are independent and identically distributed) has occurred more frequently than expected, it is less likely to happen again in the future
- echoes widespread belief of mean reversion (there are observations that support mean reversion but no purely statistic reason why it should occur)
- selling a security that has done well purely on the back of series of positive price movements (not it being expensive fundamentally)
Availability bias
Tendency to use info the comes to mind quickly/easily when making decisions
Tend to OW more readily avail info on bias that if came to mind quicker must be more relevant/important
Also OW info presented in format consistent with choice format (e.g. if decision is numerical then prefer info presented numerically)
Practical - manipulating info to more useful form
Hindsight bias
Availability bias + representativeness = hindsight bias
Tendency for investors to find an event to have been predictable after the fact (despite little/no evidence that it would happen beforehand)
Links to overconfidence bias - can make investors overly confident in future decisions as they believe they can see into future
e.g. post GFC investors convinced themselves it was obvious returns were going to be disastrous despite 07 strategy forecasters predicting high levels of return
Herd behaviour
Tendency for investors to follow eachother due to strong social preferences to conform
- bad decisions perceived as being less incorrect if everyone was wrong together
- can lead to indivs making decisions they wouldnt have ordinarily made
- can result in formation of asset bubbles = self fulfilling prophecy
- dot com bubble - investors eager to take part in trend w/out looking at fundamentals/val metrics. when investors realised comps had little/no revs and were essentially worthless started selling out bursting bubble - Nasdaq down 80% from 2000 peak by 2002
Confirmation bias
Tendency for indivs to seek out info that confirms vs contradicts their existing position
- and interpret ambiguous info as supporting their viewpoint
-unhelpful filter of potentially good ideas if they dont conform to prior belief
- failing to see info that challenges belief system and can lead to poor/outdated investment decisions
Mental accounting
Mental accounting refers to the different values a person places on the same amount of money, based on subjective criteria, often with detrimental results -
people frame assets as belong to different, non fungible catergories/accounts
often leads people to make irrational investment decisions and behave in financially counterproductive or detrimental ways, such as funding a low-interest savings account while carrying large credit card balances
e.g. spending discretionary bonus in a way you wouldnt spend regular income
mental accounting suggest marginal propensity to consume from each account is different
To avoid: the mental-accounting bias, individuals should treat money as completely interchangeable no matter where they allocate it—whether to a budget account (everyday living expenses), a discretionary spending account, or a wealth account (savings and investments).
Bounded rationality
Bounded rationality is the idea that rationality is limited when individuals make decisions, and under these limitations, rational individuals will select a decision that is satisfactory rather than optimal.
Present bias
Tendency to give stronger weight to payoffs that are closer to present time
Implies higher discount rate for now vs future
Tendency to discount future in favour of present
overvalue more immediate rewards or benefits at the expense of future rewards or benefit
can lead people to make irrational decisions that favor short-term gains - often @ expense of LT wellbeing
can take form of hyperbolic discounting = where investors discount value of future rewards far more steeply as they get closer to the present
Example: Choosing $100 now over $110 in a week, but preferring $110 in 53 weeks over $100 in 52 weeks
How to avoid present bias in investments
Debias people from retiring early and drawing from pension with messaging = pension pot growing at max rate
most people retire before state pension age but have not planned to retire early
Adopt LT investment strat that requires disciplined, consistent investment over time
Prospect theory
PT says that losses and gains are valued differently - AKA as loss aversion theory
investors will make decision on perceived gains vs percieved losses (e.g. £50 vs 50% chance of £100 = same value but people will chose £50)
- preference for certain outcomes over probabalistic ones
says that standard finance model of rational agents doesnt explain how most people undertake financial decision making
behaviours of investors are outcomes of prospect theory
prospect theory investors sell winners too early but do not like to sell shares that are at a loss relative to a reference point - risk averse for gains and risk seeking for losses
- important for framing risk - 90% chance of success vs 10% chance of failure
Regret aversion
Desire to avoid feeling pain from poor investment decision
- including pain of responsibility for making decision (not just financial pain)
- both for client and advisor, automatic rebalancing can help
Encourages holding on to poorly performing shares to avoid crystallizing loss and acknowledging poor decision has been made
Biases new decisions = avoiding investments that have performed poorly in the past
Investors prefer strong consensus judgements (wrong together>wrong alone) - may enforce herd behaviour/FOMO/decision making with ref to peergroup
Loss aversion + reasons for
Most important driver in human decision making
Investors dont experience losses and gains with the same intensity
- higher degree of emotional intensity with losses vs gain
leads to premature realization of gains and loss avoidance on the downside
advisors must help clients avoid this, explain future prospects of investments
Lack of financial capacity to bear loss
- low no. of remaining working years (worse if retirement is cap intensive)
- specific near term financial commitment
Lack of capacity to understand investment losses
- not understanding cap at risk and LT outcome may be unaffected
- more to do with psych than knowledge and may be hard to train out of people
Phych reluctance/unwillingness to bear loss
- some people naturally v risk averse despite having capacity to bear loss
Mental accounting
Mental accounting refers to the different values a person places on the same amount of money, based on subjective criteria, often with detrimental results -
people frame assets as belong to different, non fungible catergories/accounts
often leads people to make irrational investment decisions and behave in financially counterproductive or detrimental ways, such as funding a low-interest savings account while carrying large credit card balances
e.g. spending discretionary bonus in a way you wouldnt spend regular income
mental accounting suggest marginal propensity to consume from each account is different
To avoid: the mental-accounting bias, individuals should treat money as completely interchangeable no matter where they allocate it—whether to a budget account (everyday living expenses), a discretionary spending account, or a wealth account (savings and investments).
Info/noise traders
Info trader
According to MPT - this is how to adopt success = become info trader
High qual info = key to profitable investment strategy
suggest people who trade on info are correct in rationally expecting to make profit -
opposite to noise trader
Noise trader
Opposite of info trader
Make trading decision without use of fundamental data - relies on trend/sentiment/anomalies/momentum
KYC information
- personal details (name, address, dob, tax residency, domicile, product eligibility)
- health (can influence risk taking, vulnerability, life expectancy, income production? annuities, NT and LT goals)
- family and dependents (names, ages etc, their attitude to risk and influence, school fees etc)
- occupation, earnings, income, sources of wealth, future changes (knowledge/experience, conflicts, PEP - blind trust)
- estimates of present and anticipated outgoings (future house purchases, budgeting, children etc, emergency funds- 6m)
- assets and liabilities (location of assets, tax treatment and wrappers, CGT acquisition costs, early encashment penalties)
- pension arrangements/life assurance (protections, managed in conjunction?, contributions elsewhere)
- potential inheritances and estate planning arrangements (any trusts they are beneficiaries of, future big lump sums, specific gifts of shares in wills)
Risk profile
- assessed qualitatively and quantitively
- not exact science - risk profiling tool may have numeric output but risk not linear
- client may also have misunderstood questionnaire
- helps to make risk feel risk with max drawdrown etc
- 3 main areas + need
Risk tolerance
- the amount of loss an investor is prepared to handle
- based on time horizon, goals etc
- can change throughout life or with different pots (e.g. 20yo SIPP vs 70 yo SIPP)
Attitude to risk/ risk perception
- subjective willingness to take risks shaped by psych preferences and experiences
- can have different attitude with different pots of money (mental accounting)
Risk capacity
- financial capacity to withstand losses
Need to take risk
- in order to meet their financial goals
Risk tolerance
- the amount of loss an investor is prepared to handle while making an investment decision
- investor’s ability and willingness to lose some or all of an investment in exchange for greater potential returns
- degree of uncertainty an investor can handle
- can change throughout life or with different pots (e.g. 20yo SIPP vs 70 yo SIPP)
Objective factors
- timescale
- family commitments
- overall family wealth
- stage of life/marriage
- age
Subjective factors
- knowledge and experience
- psychological makeup
-upbringing
- extent of regret aversion
Risk perception/ATR
- subjective view on risks of specific investments vs alternative based on knowledge and experience
- intuition, inferences made from media etc
- can have different attitude with different pots of money (mental accounting)
- educate clients of factual risk/rewards of asset classes vs perception
- can be influenced by cognitive biases and emotional state
Risk capacity
Risk capacity
- financial capacity to withstand losses
- largely factual based on asset base, income, use of portfolio etc
- ability to bear loss can also depend on goals
Risk profiling tools
Not an exact science but can be contribute to establishing a client’s ATR - often numeric score but risk not linear
Risk descriptions
- Quali approach, describe different attitudes to see which fits best with client’s. imple
- Easy to misinterpret ‘medium’ or 5/7
Psychometric risk profiling
- assess psychological risk tolerance/pref not objective financial capacity
- questionnaire generates risk score
- good starting point but not in isolation
Stochastic modelling
- software often includes risk profiling questionnaire to help categorise clients
- model can then forecast returns based on level of risk
- helps to make investment risk real but obvs reliant on assumptions, clients may think these are more certain than they are
FCA risk profiling guidance
- no prescriptions on how firms establish client risk, but requires robust procedures and risk cat descriptions + assessment of suitability of investments against these cats
- procedures must includes - assessing capacity for loss, identifying where cash is more suitable due to extreme risk aversion
- tools must be fit for purpose and limitations understood
- questions must be fair, clear, not misleading
- must ensure investments are suitable given objectives, financial situation and risk profile
- must understand nature of products selected for customers
- must engage customers in suitability assessment process which acts in best interests of customers
Investment objectives
Maximising future growth
Protecting value of capital
Generating essential levels of income
Provision for future events (e.g. uni costs)
Protection pols for IHT
Simply
Income = higher level of income at expense of future capital growth
Income/growth balanced = certain amount of income but wants to achieve potential future growth of income and capital
Growth = not seeking specific income and primary objective is capital appreciation
Max growth = generally highest risk seeking max level of return
Tax treatment different so can affect goals
Liquidity reqs
- client may have known liabilities in the future, or may regularly take ad hoc income from portfolio - strat should account for vol in markets and have suitable readily releasable funds
- Liquidity = funds a client may need in LT and ST
- Plan on where (asset class and tax wrapper) to release capital from
- Planning - amount of cash buffer that should be held + liquidity of UL assets in portfolio which can be released in emergency
- bond ladders can be useful here
- higher liquidity and shorter timescale generally means lower risk and restricts choice of assets
Time horizon
- generally = period over which client will be investing funds. LT = 10+, ST<4
- important when selecting investments as more vol = less suitable for shorter time periods (equities >5y)
- LT horizon allows you to endure periods of market vol
- lifestyling of investments over life to reduce risk as retirement approaches and increase income (also do this for house purchaes etc)
What to establish re tax status
- v important re tax income/gains will be subject to and influences portfolio construction
- e.g. HR taxpayer may bias towards capital growth due to lower tax rate applied and the fact CGT realisation can be timed
- res and dom
- income tax position and anticipated changes
- attitude towards tax
- any allowances
- CGT losses/gains (losses carried forward)
- eligibility for tax free accounts
-marital status and inter spousal transfers
Net assets statement - assessing client financial posi
Net assets statement
- personal balance sheets showings assets, liabilities and net worth
- asset allocation summary also useful to compare against client’s risk profile
Questions
- asre assets appropriate for client objective?
- why is there an overallocation to certain assets?
- how likely are targets to be met
CF statement- assessing client financial posi
- shows income and expenditure asset by asset (net)
- quantifying income shortfall that needs to be generated by investments
- identifying where there is surplus income and opps to put this to work if poss
- current CF can be used to estimate future income/what would happen if client became ill/unable to work
Tax analysis - assessing client financial posi
- understanding of how client is taxed is essential + helps ascertain whether returns via income generation or capital growth are more efficient
- ops for HR tax relief on pension contributions
- tax relieved investments e.g. VCTs, EIS, SEIS
- spreading assets between spouses to make use of PSA/divi allowances or NRB for IHT
- spreading CGT disposals over years to make use of annual allowances
- likelihood that client will be BR taxpayer in future (useful for bond rollup etc)
suitability reqs for client personal info
- client can afford investment/product
- client understands risks and how recs meet their needs
- clients must be aware of importance of providing up to date info
- advisor must undertake assessment of client knowledge/experience/risk tolerance including ability to bear loss
- tools employed in suitability process must be appropriately designed and limitations known
- taking steps to assure consistency of client info and questioning obvious inaccuracies
Examples of unsuitable investment selection outcome
when firms
- dont take account of all client’s objectives/situations and knowledge/exp
- fail to challenge where auto generated investment selection is unsuitable for individual client
- failure to ensure recs are consistent with risk description
- reliance on vol solely as proxy for risk
- not recognising importance of diversification
- dont understand nature and risks of prods selected for clients
Assumptions made in financial plan
- assumed rates of return
- future inflation rates
- future expenditure patterns
- rate of earnings increases
- school and university fee increases
- annuity and/or pension drawdown rates
- future tax rates
- life expectancy, and
- future social security benefits.
Record on plan that these are assumptions and recs are based on these - show why they are reasonable and relevant to financial plan
Assessing suitability of investment decision
Suitability assessment means the whole process of collecting information about a client, and the
subsequent assessment of the suitability of a given financial instrument for that client.
Suitability rules apply when firms make personal recs related to designated investments and when they manage investments
3 elements
1 - Knowledge and exp
- in investment field relating to specific investment or service
- to understand risks/transaction/management of portfolio
- should include real world examples e..g max drawdown to make risk feel real
- Financial situation
- ability to bear investment risks consistent with objectives - Investment objectives
- preferences regarding risk taking, length of time to hold, risk profile and purpose of investment
- holding period specifically important for illiquid instruments
FCA guidance on assessing suitability
Firm must take reasonable steps to ensure rec/decision to trade is suitable for customer
- firms must therefore obtain sufficient customer info that is required to understand whether or nor a decision is suitable
does specific transaction/rec…
- meet the customer’s investment objectives
- is customer able to bear risks consistent with objectives
- does customer have necessary exp/knowledge to understand risks
failure to obtain relevant info can lead to rec/transaction being unsuitable
Suitability report
- doc that explains why recs/strategy is suitable for financial needs/objectives/risk profile
- best practise is an outline of client circs and needs, summary of recs with detailed sections on risk profile, AA, investments and wrapper selection
- may be needed on ongoing basis where firm provides PM services or firm has informed client it will carry out periodic assessment of suitability
- updated statement must contain info on how investments meet objectives, pref and risk characteristics of client
Content of a suitability report
Cover, contents, intro
Objectives - statement of priorities, areas of considerations
Assumptions - included in financial plan
Client info
- Attitudes - risk profile, attitude to saving, morbidity, mortality etc
- KYC info, tax, time horizon etc
Financial circs
- assets + liabilities
- Income and expenditure - identifying surplus/deficit
Recs - + how they meet client objectives, action plan, what next, who does what action
- costs + impact on returns
- other options considered
Reviews - info about purpose and importance, timescale, who initiates, importance of keeping informed
What must advisor provide client with if they rec a product
- client agreements
- suitability reports
- product information
- key features documents
- illustrations
- key information document (KID)/key investor information document (KIID)
- aggregated costs disclosure
- copy of the fact find, and
- terms and conditions.
+ any risk warnings
Insistent clients
- client to whom firm has given rec + client then decides do something v different from rec and for firm to facilitate this
- can lead to poor outcomes
- e.g. boom of DB transfers post increases in pension freedoms
FCA says firms should make it clear
- communicate clearly what their advice is and why they gave it
- what piece of advice is being acted against
- that any further advice given is subsequent to the specific action requested by the insistent client’.
- produce distinct suitability reports for advice acted against and any further advice
- be clear with the client about the risks of their chosen course of action
FP review + factors
FP should be reviewed at least every 12m - regulatory requirement where there is ongoing advice
- reviewing the previous advice in light of any changes changes to circs
- changes to goals and the amounts targeted
- reviewing and amending the assumptions
- changes in market conditions
- net worth and income and expenditure
- asset allocation and client risk profiles (including rebalancing portfolios)
- time horizons
- suitability of products and product wrappers held and revisiting the risk appetite and capacity for
loss of the client - reviewing ATR
- summarising the charges of the product, underlying fund costs, transaction costs, and adviser
charges applied on an annual basis.
if there are significant changes may need a whole new plan but if not can adapt current one
Fees and FCA views on advice
- both independent and restricted advice paid for by what’s known as ‘advisor charging’
- can be hourly or flat fee or % AUM
- client still must pay if they decide not to go ahead with plan due to costs sustained by advisor (normally agreed up front)
- FCA suggests an increase in transactional advice > ongoing advice may be what’s best for clients broadly
- investors can be broadly unaware of what they are paying for advice - research done by FCA found this
