Series 7 Chapter 3 Flashcards
KYC
The know your customer (KYC) rule places an obligation on the firm and associated person to seek information from customers. Customers are not required to provide all information asked; therefore, the KYC rule provides some flexibility when information is unavailable, despite the fact that the firm or the associated person asked for it.
In this case, when some customer information is unavailable despite a firm’s request for it, the firm may narrow the range of recommendations it makes. The rule does not prohibit a firm from making a recommendation in the absence of certain customer-specific information if the firm has enough information about the customer to have a reasonable basis to believe the recommendation is suitable based on what the firm knows. The significance of specific types of customer information will depend on the facts and circumstances of the particular case. Of course, the firm itself may require, in order for customers to receive recommendations, that customers provide certain types of information.
Both financial and nonfinancial information must be gathered before making investment recommendations.
Before making a recommendation for a new customer a representative must
must try to find out as much about that person’s financial and nonfinancial situation as possible. Financial investment considerations can be expressed as a sum of money. Financial questions have answers that show up on a customer’s personal balance sheet or income statement. Asking a customer, “when would you like to retire?” is not a financial question—it is nonfinancial. The answer does not show up on the customer’s personal balance sheet or income statement.
customer balance sheet
An individual, like a business, has a financial balance sheet—a snapshot of the individual’s financial condition at a point in time. A customer’s net worth is determined by subtracting liabilities from assets (assets – liabilities = net worth). Representatives determine the status of a customer’s personal balance sheet by asking questions similar to the following.
■ What are the values of tangible assets? Home? Car? Collectibles?
■ What are your liabilities? How much do you owe on your mortgage? Car? Outstanding
Loans?
■ What are the values of securities you currently own?
■ Have you established long-term investment accounts, and what are the values of those accounts? Do you have an IRA, corporate pension, or profit-sharing plan; and what are the values of those plans? What is the cash value of your life insurance?
■ What is your net worth? How much of it is liquid?
customer income statement
To make appropriate investment recommendations, representatives must know the customer’s income situation. They gather information about the customer’s marital status, financial responsibilities, projected inheritances, and pending job changes by asking the following questions.
■ What is your total gross income? Total family income?
■ How much do you pay in monthly expenses?
■ What is your net spendable income after expenses? How much of this is available for investment?
Before recommending any investment to a customer, a representative must,
at a minimum, make a reasonable effort to obtain information concerning the customers financial status and investment objectivies
customer profile:non financial investment considerations
Once representatives have an idea of the customer’s financial status, they gather information on the nonfinancial status. A nonfinancial investment consideration is one that cannot be expressed as a sum of money or a numerical cash flow (risk tolerance, or tax bracket, for example). Nonfinancial considerations often carry more weight than the financial considerations and include the following:
■ Age
■ Marital status
■ Number and ages of dependents
■ Employment
■ Employment of family members
■ Current and future family educational needs
■ Current and future family health care needs
■ Risk tolerance
■ Attitude toward investing
■ Tax status
No matter how much an analysis of a customer’s financial status tells the representative about the ability to invest, it is the customer’s emotional acceptance of investing and motivation to invest, which molds the portfolio.
To understand a customer’s attitude for investment, the representative should ask questions similar to the following.
■ What kind of risks can you afford to take?
■ How liquid must your investments be?
■ How important are tax considerations?
■ Are you seeking long-term or short-term investments?
■ What is your investment experience?
■ What types of investments do you currently hold?
■ How would you react to a loss of 5% of your principal? 10%? 50%?
■ What level of return do you consider good? Poor? Excellent?
■ What combination of risks and returns do you feel comfortable with?
■ What is your investment temperament?
■ Do you get bored with stable investments?
■ Can you tolerate market fluctuations?
■ How stable is your income?
■ Do you anticipate any financial changes in the future?
risk points
■■ Low risk—conservative
■■ Some risk—moderate
■■ More than average risk—moderately aggressive
■■ High risk—aggressive
If you key on the right word, you’ll get the correct answer.
preservation of capital
For many people, the most important investment objective is to preserve their capital. In general, when clients speak of safety, they usually mean preservation of capital. Recommendations may include the following:
■ Money market securities
■ Money market mutual funds
■ Certificates of deposit (CDs)
■ Government securities
■ Principal-protected funds may also be appropriate if they are looking to invest for a longer time horizon
current income
Many investors, particularly those on fixed incomes, want to generate additional current income.
■ Traditional debt securities such as corporate, government, municipal bonds, and agency securities may provide steady interest income.
■ Equity securities may be purchased for the dividends they produce; these include preferred stocks, utilities, and blue-chip stocks that have a solid dividend paying history. (A blue- chip stock is the stock of a large, well-established and financially sound company that has operated for many years and is usually a company people are familiar with.)
■ Many pooled investments can provide income as well, such as income-oriented mutual
capital growth
refers to an increase in an investment’s value over time. This can come from increases in the security’s value. Growth-oriented investments are equity oriented.
price to earnings ratio
Measures the relationship between a company’s
stock price, with the company’s earnings per share (EPS). The P/E ratio indicates how
much investors are willing to pay for a every dollar of earnings.
A high P/E ratio indicates investors expect higher earnings (growth momentum).
A low P/E ratio may indicate the stock is undervalued and may be more representative of a value investment.
higher the pe ratio
the better
tax advantage products
Investors often seek ways to reduce their taxes. Some products, like IRAs and annuities, allow interest to accumulate tax-deferred (an investor pays no taxes until money is withdrawn from the account). Other products, like municipal bonds, offer tax-free interest income.
are municipal bonds suitable for retirement accounts
no
liquid investments include
securities listed on an exchange or unlisted Nasdaq securities; ■ mutual funds;
■ exchange-traded funds; and
■ real estate investment trusts (REITs).
illiquid investments include
■ annuities, when initially purchased and/or when the annuitant is under age 591⁄2; ■ real estate;
■ direct participation programs;
■ hedge funds; and
■ funds of hedge funds.
annuities and liquidity
Annuities—particularly when issued—are not considered liquid. Most annuities have a surrender penalty that may last at least seven to 10 years. In addition, there are taxes and a 10% tax penalty for withdrawals before 591⁄2 years of age.
speculation
A customer may want to speculate—that is, try to earn much higher-than-average returns in exchange for higher-than-average risks. Investors who are interested in speculation may be interested in:
■ option contracts;
■ high-yield bonds;
■ unlisted or non-Nasdaq stocks or bonds;
■ sector funds;
■ precious metals; and
■ special situation funds.
As a registered representative, one must always determine the suitability of such recommendations.
recommendation for preservation of capital/safety
CDs, money market mutual funds, fixed annuities, government securities and funds, agency issues, investment-grade corporate bonds and corporate bond funds
Growth (balanced/moderate growth)
(aggressive growth)
recommendation
Common stock, common stock mutual funds Blue-chip stocks, defensive stocks Technology stocks, sector funds
income
(tax free income)
(high yield income)
(from stock portfolio)
recommendation
Bonds (but not zero coupons), REITs, CMOs
Municipal bonds, municipal bond funds, Roth IRAs
Below investment-grade corporate bonds, corporate bond funds Preferred stocks, utility stocks, blue-chip stocks
liquidity recommendation
Securities listed on an exchange, Nasdaq stocks or bonds, mutual funds, publicly traded REITS
portfolio diversification
recommendation
Mutual funds, in general; more specifically, asset allocation funds and balanced funds
For equity portfolios, add some debt and vice versa For domestic portfolios, add some foreign securities For bond portfolios, diversify by region/rating
speculation recommendation
Option contracts, DPPs, high-yield bonds, unlisted/non-Nasdaq stocks or bonds, sector funds, precious metals, commodities, futures