UNIT 04.02-002 Flashcards
A registered representative is talking with a new customer at his firm, a 60-year-old man who has accounts at several other broker-dealers and a net worth of just over $700,000. The customer considers himself to be extremely skilled at selecting new companies that will perform well, and over the years, through numerous small investments, he has built a portfolio consisting of about 80% equity securities. His company mandates retirement for its personnel at age 65, and he is becoming worried about retirement income. He has selected another new company, one with a speculative bond issue. He would like to invest $250,000 in this issue to augment his projected retirement income and would like the registered representative’s opinion. The registered representative should
agree that it is appropriate to move toward emphasis on income, if that is his retirement objective, but not with such a large investment in one speculative security.
This investment would amount to over one-third of the customer’s net worth and is speculative to boot. The registered representative should urge the customer to begin moving more slowly into income securities. Index funds are not purchased for income, the sector fund is speculative and not income oriented, and although high-yield bond funds are income oriented, they are also speculative. So, the overall mix is not the best recommendation.
=====
To understand the advice given by the registered representative, let’s break this down using a simple analogy.
Imagine the customer’s portfolio is a garden, where up until now, he has primarily planted “equity flowers,” making his garden vibrant and colorful, but also somewhat susceptible to bad weather (market volatility). As retirement approaches, akin to preparing for a season change, the customer realizes he needs more “income vegetables” in his garden to ensure a steady food supply (stable income) during his retirement years, rather than just beautiful flowers.
However, the customer’s idea of planting a large, exotic, and speculative “income vegetable” (the speculative bond issue) worth a substantial portion of his garden’s value is akin to betting a third of his garden space on a crop that is not guaranteed to grow and may not even be suitable for the climate (market conditions). This move could endanger his food supply if the crop fails, especially as he nears the time when he’ll rely on it the most.
The registered representative’s advice is like suggesting that, while it’s a good idea to start planting more vegetables for the coming season, it’s not wise to risk so much on a single, uncertain crop. Instead, diversifying the garden with a variety of reliable, income-producing plants (securities) would be a safer and more prudent approach to ensure a steady and dependable harvest (income) in retirement.
Therefore, the representative advises against making such a large investment in one speculative security, considering it constitutes over one-third of the customer’s net worth and carries high risk. The suggestion to move more slowly into income securities is about gradually adjusting the garden to include more stable, income-producing plants, ensuring a balanced approach to risk and income as retirement approaches. This approach aims to safeguard the customer’s financial well-being by promoting diversification and stability, rather than putting a significant portion of his resources into a potentially high-risk investment.
Which of the following is not a financial consideration?
A customer’s education level
Financial considerations are those that are expressed as a dollar amount of a stream of payments. Financial considerations may be found on a customer’s balance sheet or income statement.
If an investor has $20,000 to invest, but requires $500 per month to pay for her mother’s nursing home care, which of the following funds should you recommend?
Money market
The client’s monthly income requirements suggest that the money market fund, the most liquid and safest of the investments, is the most appropriate.
Your customer wishes to invest $25,000 using investment company securities as a means of diversification, but she states that she is not comfortable with stock market risk. Which of the following fund types would be the least appropriate recommendation?
Blend/core fund
Stock market risk is reduced by owning shares of bond funds, particularly those containing government or municipal bonds. Of the equity funds, the balanced fund is generally considered to offer the greatest protection of principal. Blend/core funds, which own value and growth stocks and even some blue-chip stocks, carry a higher degree of market risk than these others.
====
Let’s use an analogy to help understand why a blend/core fund would be the least appropriate recommendation for a customer uncomfortable with stock market risk, who wishes to invest $25,000 for diversification.
Imagine the customer’s investment as deciding where to vacation to avoid bad weather. In this scenario, bond funds are like vacationing in a mild climate area where weather extremes are rare—representing a lower risk of bad weather (or stock market risk). Government or municipal bond funds are akin to choosing a destination known for its stable, predictable climate (low-risk investment options).
Now, among equity funds (which are more like vacation spots with varied weather patterns), a balanced fund is like a destination that offers a mix of beach and mountain climates, balancing sunny days with cooler, more manageable temperatures. It’s generally safe and offers protection against extreme weather (or loss of principal) because of its diversification between stocks and bonds.
A blend/core fund, on the other hand, is like a destination that offers a mix of city, beach, and mountain climates—value stocks, growth stocks, and even some stable, well-established (blue-chip) stocks. While this mix might sound appealing for a vacation offering variety, in investment terms, it still exposes you to the unpredictability of the stock market weather (risk), including the potential for storms (market downturns). For someone specifically seeking to avoid the risk of bad weather (stock market risk), choosing a destination (investment) known for its potential for storms wouldn’t be appropriate.
Therefore, for a customer looking to diversify without taking on too much stock market risk, suggesting a blend/core fund—which, despite its diversification, still leans heavily on equities—is akin to recommending a vacation spot where the weather could change rapidly, potentially leading to the very conditions they hoped to avoid. This makes it the least suitable option compared to more conservative investments like bond funds or a balanced fund, which offer a more stable climate (risk profile) suitable for the customer’s needs.
Which of the following would be found on a customer’s income statement?
The customer’s income
An investment representative recommended a variable annuity to a client who declined the investment. The same client called a year later and wanted to buy the annuity and invest all the funds in the aggressive growth portfolio, which had had a remarkable three-year performance streak. The client is one year away from retirement. Which of the following statements are true?
The client’s profile must be updated to ensure suitability before selling him the variable annuity.
The aggressive growth portfolio is not suitable because the client will retire in a year.
Because of the client’s potential retirement needs, the aggressive growth portfolio would not be suitable for a substantial portion of his funds. His profile should be updated before making any recommendation.
Your client, age 28, has just begun to consider investing outside of her employer’s 401(k) plan. She’s saved $25,000 to allocate toward some capital appreciation and some income. She prefers an investment with moderate risk and some downside protection if the stock market falls. With investing being new to her, she wants to note that she understands and is comfortable with moderate risk as stated, only. Given what has been conveyed, which of the following would be the most suitable?
Balanced fund
A balanced fund that consists of both equities and debt instruments not only aligns with the growth objective but also, because of the debt instruments in the portfolio, adds some downside protection against falls in the market. An index fund and equity income fund are both subject to market risk should the market turn downward. Sector funds are considerably more aggressive and not suitable for an investor with moderate risk looking for some downside protection.
An accredited investor, age 39, would like to invest $10,000 and wants an investment that is liquid. You recommend
a mutual fund that invests in both stocks and bonds.
A product is liquid if a customer can sell it quickly at face amount (or very close to it) or at a fair market price without losing significant principal. A mutual fund is the only choice given that is considered liquid.
A moderate-risk customer who has been funding a self-directed IRA since her late 20s is now in her early 60s. The investment vehicle currently weighted heavily toward equities for growth has allowed her to accumulate a robust nest egg to be used during retirement. Hoping to keep the IRA investments limited to mutual funds, she asks for a more conservative allocation given her age. Which of the following is suitable and conservative allocation?
70% balanced fund, 30% U.S. government bond funds
As this customer gets closer to retirement, the need to move away from equities toward fixed income should be evident. A balanced fund that is split between equities and debt securities coupled with U.S. government bonds that are considered safe and with no default risk is appropriate. An immediate red flag should arise regarding the use of municipal bonds (or funds) in a tax-favored account. With tax-free interest, there is no suitable reason to utilize such assets in an IRA. A 60% position in high-yield bond funds are speculative and not suitable for a conservative portfolio.
====
To break down this concept, let’s use a metaphor involving a journey, where the moderate-risk customer’s retirement is the destination, and her self-directed IRA is the vehicle she’s using to get there. Throughout her working years (her 20s to her early 60s), she’s been traveling on a highway with her vehicle heavily loaded with “equities fuel” - which is akin to using a high-speed, somewhat riskier path to grow her resources for the trip. As she gets closer to her destination (retirement), she realizes the need to switch to a safer, more reliable route to ensure she arrives smoothly and with her resources intact.
The Customer’s Request for a More Conservative Allocation
Asking for a more conservative allocation within her IRA, limited to mutual funds, is like wanting to switch from the high-speed, riskier highway to a safer, more scenic route. She wants to ensure her journey to retirement is secure and less susceptible to unexpected downturns.
Why 70% Balanced Fund and 30% U.S. Government Bond Funds?
- 70% Balanced Fund: This is akin to choosing a versatile vehicle equipped for both highways and safer, scenic roads. Balanced funds invest in a mix of equities (stocks) and fixed income (bonds), providing both growth potential and income with moderate risk. It’s like having a vehicle that’s efficient in fuel consumption (risk) but still capable of decent speed (growth).
- 30% U.S. Government Bond Funds: This is like adding an extra safety feature to the vehicle. U.S. government bonds are considered some of the safest investments because the chance of the U.S. government defaulting on its debt is extremely low. Investing in these bond funds is like equipping the vehicle with advanced safety systems, ensuring that a significant portion of the journey towards retirement will be smooth and secure.
The Immediate Red Flag Regarding Municipal Bonds in an IRA
Municipal bonds are like a special fuel that’s tax-free - it’s beneficial in certain vehicles but not in the IRA vehicle which already has tax advantages. Since the IRA offers tax-deferred growth, using municipal bonds, which main advantage is their tax-free interest, doesn’t make sense. It’s like using a fuel that’s designed to be tax-efficient in a vehicle that already operates tax-free; the primary benefit of the fuel is wasted.
High-Yield Bond Funds Being Speculative
Lastly, a significant allocation to high-yield bond funds for a conservative portfolio is like choosing a riskier path when safety is the priority. High-yield bonds, often called “junk bonds,” offer higher interest rates because they come with higher risk. For someone nearing retirement, taking a path filled with potential hazards (speculative investments) doesn’t align with the goal of a smooth and secure arrival.
Therefore, the combination of a 70% balanced fund and 30% U.S. government bond funds offers a suitable and conservative allocation for the customer’s IRA, providing a balance between safety and moderate growth as she approaches retirement.
Mr. and Mrs. Smith, both nearing retirement, want to maximize their income. They want to reallocate $100,000 of their $400,000 portfolio of securities for this purpose. Of the possible investment choices below, which would be the least suitable recommendation given their investment objective?
AAA convertible corporate bonds
Convertible bonds offer a lower coupon in exchange for the conversion feature and, therefore, are not a good choice for maximizing income.
