Chapter 7 (11 exam questions) – The Investment Advice Process

Question 1

FOR CONTEXT: The 6 official steps to giving advise are:

Answer 1

see image

Question 2

This chapter links heavily with chapter 8

Answer 2

Question 3

What is the purpose of the client agreement (also called customer agreement)

Answer 3

This tells the client about the services offered by the advisor,

This includes remuneration, how often reviews will take place and so on

Question 4

What does the fact find establish

Answer 4

Soft and hard facts

Hard facts relate to factual information such as a customer’s salary and occupation.

Soft facts refer to their needs, wants, desires and feelings.

Question 5

Answer 5

Question 6

There are three main factors to consider when creating someone’s risk profile

What are they?

Answer 6

What is their attitude to risk (subjective)?

What is their tolerance to risk (subjective)?

What is their capacity for loss (objective)?

Question 7

A questionnaire is typically used as part of the factfind. Why is this?

Answer 7

A good questionnaire aims to elicit a personal response rather than a reaction to what everyone else is doing. People often tend to imitate others (herding) and this could mean their answers about their risk tolerances are skewed. Good questionnaires prevent this

Modern questionnaires usually incorporate questions that will elicit attitudes and tolerances.

They would have questions such as: “How would you feel if the value of your investments fell by 25%”, with a range of answers to choose from.

Question 8

What is mental accounting in relation to attitude for risk?

Answer 8

It is a term used for this whereby a customer may be prepared to accept a higher risk on say their regular savings than when investing a lump sum

Question 9

What are ‘stochastic’ modelling tools.

Answer 9

The range of possible returns from a selected asset allocation can be measured over any period of time, and a model of ‘likelihood’ can be created.

This enables them to link risk discussions directly to asset allocations.

Question 10

When it comes to a portfolios performance. What typically has a bigger effect. Asset allocation or the individual selection of stocks themselves?

Answer 10

Asset allocation

Question 11

Why is it not fair to bracket all equity funds as higher-risk

Answer 11

A fund investing in established UK shares will generally be less risky than one that invests in smaller companies like ‘alpha’ funds.

Question 12

Ethical funds differentiate themselves through different types of screening.

Tell me about this

Answer 12

The different types of screening (see image)

Question 13

Generally, it is easier to invest ethically through collective investment schemes, which will have rigid screening processes in place. WHY?

Answer 13

Trying to screen directly is very difficult with a number of investments and very subjective.

Question 14

Clients may initially want to achieve a particular return, but it’s not until an adviser brings risk tolerance into the conversation that a more achievable or acceptable objective emerges.

This is where an adviser’s soft skills can come to the fore by asking ‘what if…’ or ‘how would you deal with…’ questions.

There are two main Investment types that these objectives fall into: WHAT ARE THEY

Answer 14

Question 15

There are five accepted risk categories into which investors can be classified.

These are:
No risk
Low risk (cautious)
Medium risk (balanced)
Medium/high risk (adventurous)
High risk (speculative)

Tell me the differences between each, including what the typical investments found under each type are and what is accepted/not accepted in relation to investment performance

Answer 15

Question 16

Context

Answer 16

Question 17

What is time horizon

Answer 17

When considering an investment, an adviser needs to take into account the timeframes the customer has.

Risk is closely related to time horizon, especially with equities. Equities experience the widest fluctuations in value, and investing in these over short time-periods can be very risky. Research has shown that equities only really start to consistently beat other asset class returns after ten years or more, so an investor must be prepared to invest for the long haul.

Question 18

Is it better to repay debts with your money or save and invest it?’

Answer 18

Secured debts should always be repaid first. Although they typically carry lower interest rate, the ramifications of default mean that it is better to carry unsecured debt. Certain expenditure, such as mortgage payments, council tax, utilities should always take priority in a customer’s budgeting.

Question 19

Using the concept of ‘asset allocation’ means that an adviser can create pre-designed portfolios that are tailored to the needs of ‘classes’ of customers.

Answer 19

Question 20

What does Personal Investment Management and Financial Advice Association (PIMFA) do?

Answer 20

Provides investors with an objective benchmark against which to measure their own investment portfolios.

This is for investors who wish to review whether their portfolios match their risk profile

Question 21

What is Tactical Asset Allocation (TAA)?

Question 22

What is Strategic Asset Allocation?

What is Tactical Asset Allocation

Answer 22

Strategic Asset Allocation (SEE IMAGE)

Tactical Asset Allocation = Where you start with a base allocation like with SAA but there is a range, for example, plus or minus 10% or 20%. The investor can overweight or underweight an asset class depending on how valuable they see it

In the images example if it was TAA instead with the same base allocation, shares could go anywhere between 40% and 80%, bonds anywhere between 10% and 50% and cash zero to 30%.
These are known as ‘strategic ranges’

A fund manager is ‘applying his skills’ far more in a tactical model than in a strategic one.

Question 23

Where does a fund manager apply their skills more. In Strategic Asset Allocation or Tactical Asset Allocation

Which one allows an investor to overweight or underweight a certain asset class?

Answer 23

Answers for both are Tactical Asset Allocation

Question 24

What are strategic ranges in relation to Tactical Asset Allocation?

Answer 24

The ranges that the fund manager must stay in when allocating the assets

Question 25

A variation of the Tactical Asset Allocation approach is 'Allocations within asset classes' . What is this?

Answer 25

In this model, the fund manager starts with a defined asset allocation model for his fund, such as the 60% shares, 30% bonds, 10% cash split that we have used so far. He stays within that, but varies the actual assets within a category. He could, for example, split the 30% bond holding so that one day it is 80% GILTS and 20% corporate bonds and then the next day it is 60% GILTS and 40% corporate bonds. He has stayed within the 30% bond holding boundary, but changed the balance of assets within it.

Question 26

Tactical asset allocations tend to only be found in growth funds. True or false

Answer 26

True

Question 27

What is rebalancing? Is it automatic or on request?

Answer 27

A form of asset allocation I client may use the Strategic Asset Allocation approach and for example, have a base split of 50% equities and 50% fixed interest (see image) However, in the example because of how the respective asset class has preformed now its moved to 61% in equities and 39% in fixed-interests. This obvs makes the fund riskier Because the fund manager must stick with the agreed allocation they 'rebalance' and bring it back to 50:50 as the investor wants Rebalancing can be done automatically or 'on request'.

Question 28

We know the meaning of accumulating wealth, but what is 'decumulating' wealth? .

Answer 28

One of the main definitions: The conversion of assets accumulated during an individual's working life into income to be spent during retired life. advising on decumulation is becoming more common as people are living longer

Question 29

Which of the following is not an advantage of using a clearly defined advice process? It provides discipline for advisers It provides an administrative template It provides a clear compliance trail It provides a defined charging structure

Answer 29

It provides a defined charging structure - it does not do this. This process is mentioned in one of the early flashcards A defined advice process has nothing to do with charges and everything to do with answers A – C.

Question 30

Mrs Jameson tells her adviser that she aims to retire at 55, but it is clear that she has insufficient plans in place. The adviser should… advise her that she must defer her retirement plans to allow time for her fund to grow recommend she cancels all her protection plans and divert the premiums into her pension make her aware that the plans she has are unlikely to be sufficient and negotiate a more realistic retirement age or income level terminate the interview and advise her that they are unable to assist

Answer 30

Answers: make her aware that the plans she has are unlikely to be sufficient and negotiate a more realistic retirement age or income level A common scenario. An adviser cannot insist that a customer does anything and certainly shouldn’t recommend the cancellation of existing protection plans. A frank discussion should take place, where more realistic aims are agreed and hopefully implemented.

Question 31

A customer's capacity for loss describes… the level of returns they are looking to achieve their own perception of their risk tolerance the level of loss that the customer's finances could withstand the amount of money a customer is prepared to lose

Answer 31

The level of loss that the customer's finances could withstand A capacity for loss is an objective analysis of whether a customer can afford to absorb potential capital losses. It is not their own perception; in fact, they are unlikely to be able to quantify it without assistance.

Question 32

Sharon is discussing her portfolio with her financial adviser. She declines one suggested approach because the fund manager invests in tobacco companies. This approach is known as… positive screening social investing neutral screening negative screening

Answer 32

negative screening Social investing is a red-herring, the other two are socially-responsible investing, where nothing will be excluded, with the fund selecting companies that follow ethical practices. Negative screening is about avoidance

Question 33

Stewart is thinking about investing £20,000, and tells you that he would be uncomfortable if the value of his portfolio fell by more than 5%. What does this tell you about Stewart? He has a low attitude to risk He has a low capacity for loss He has a low risk tolerance He should put 25% in cash so that his wealth is not adversely affected if the investment does fall by more than 5%

Answer 33

He has a low risk tolerance How a client feels when they suffer an investment loss relates to their tolerance of risk. A 5% fall is possible with most risk assets, and this would be indicative of someone with a low tolerance.

Question 34

Peter has an investment portfolio where the income from his investments is automatically reinvested. Which one of the following best describes his return objective? Capital preservation Total return Capital appreciation Current income

Answer 34

Total return The investor is reinvesting the income to benefit from compound growth which will boost the overall return of the portfolio. This is a total return objective. By reinvesting the income their objective is clearly not focussed on current income . The other objectives both focus on capital only.

Question 35

Asset allocation methodology uses diversification as a defensive strategy. This means that it… prioritises capital protection above capital growth uses tactical allocation as a counter-balance is designed to produce the highest possible return is unsuitable for income portfolios

Answer 35

Prioritises capital protection above capital growth Self-explanatory to a degree. With diversification, you are, in effect, hedging your bets. Some assets will always hold back the growth of others but in doing so will provide added protection from risk.

Question 36

Sophia, a new customer, has an existing portfolio and a medium attitude to risk. Her financial adviser has recommended that her latest investment is fully invested in GILTS. This recommendation could be justified if… interest rates are expected to rise she is a higher rate taxpayer her existing portfolio is 100% equities she is yet to utilise her ISA allowance this tax year

Answer 36

her existing portfolio is 100% equities A 100% equity portfolio would be higher than medium risk. By adding GILTS to the portfolio, it should bring the portfolio more in line with her medium ATR.

Question 37

An investment portfolio incorporating life styling would… exactly match the customer's attitude to risk increase its gilt exposure in the early years rebalance the portfolio automatically reduce its equity exposure in later years

Answer 37

reduce its equity exposure in later years As customers get older, their capacity for loss, and often their ATR, tends to reduce. Life styling is an automated feature that will reduce equity exposure in favour of GILTS to lock in gains and make the fund less volatile. It doesn't 'rebalance the portfolio', it moves to more appropriate asset classes.

Question 38

Sally has an investment portfolio of £100,000. Her main time-horizon is 10 years away, but she needs £15,000 to be available in 3 years' time. When structuring her recommendation, the adviser should… recommend the £100,000 is invested for 3 years and then consider re-investment recommend that 85% of the portfolio should be invested for 10 years, the rest for 3 years make no recommendation as the time horizons are too far apart invest the £100,000 for 10 years and withdraw the £15,000 when it's required

Answer 38

recommend that 85% of the portfolio should be invested for 10 years, the rest for 3 years Each investment amount should match its time horizon and also be considered separately for risk.

Question 39

Jensen, a fund manager, has increased the equity allocation on his fund from 60% to 70% and reduced his corporate bond holdings from 40% to 30% as he believes that the stock market environment looks positive over the next year. This is an example of… rebalancing tactical asset allocation arbitrage strategic asset allocation

Answer 39

tactical asset allocation Tactical asset allocation (TAA) for a multi-asset fund provides the fund manager with ranges for the asset allocation that he can move within to take advantage of what he believes are short-term opportunities. These also allow some flexibility in avoiding regular rebalancing, which involves bringing the asset mix back into line with strategic asset allocation. Strategic asset allocation (SAA) is long-term with usually fixed asset allocations.