Presenting the security selection

From Planipedia

Thanks to PlanPlus and WEA for sharing their material for this Best Practices Guide.

Most Important – Best practices in presenting recommendations for securities to investors rest on two essential principles:

1. Provide the client with all the information required to make an informed decision. This will include past performance, which must be accompanied by a statement emphasizing that past performance is not an indicator of future returns.
2. Ensure that the client has reasonable expectations about expected returns and volatility of those returns. Illustrate the downside potential to any recommendation as well as the upside.

With these two important principles in mind, note that just as the procedure for selecting securities described above is a progression from general decisions to specific ones, so should the presentation of the recommended securities follow the same pattern ¾ general to specific. In this instance, however, the transition traces steps already taken by reviewing decisions made earlier in the financial planning process.

The basic steps are:

1. Review the client’s personal philosophy with respect to investing
2. Restate the client’s primary and secondary investment objectives
3. Describe how the asset allocation chosen fits with #1 and #2 above
4. Describe and justify types of securities being recommended
5. Identify specific securities that meet criteria in #3 and #4 above

Let’s look at each step in more detail.

1. Review the client’s personal philosophy with respect to investing:

• Risk tolerance – describe the assessment of the client’s risk profile as determined by your asset allocation software or through discussions with the client. Explain the implications of accepting that description as being accurate. Sample statements might include something like:

You have described yourself as a moderately risk tolerant investor, This implies that you are willing to accept short-term fluctuations in your portfolio values because you believe that in the longer term, the overall return from investments which do occasionally decline will have a greater likelihood of meeting your objectives. Do you still feel that way?

OR

You have indicated that you are a very conservative investor and do not want to risk any of your portfolio, if possible. You understand that this will restrict the number of investment options available to you to those that have historically had low volatility, which also will likely mean accepting lower long-term returns than might be available with more aggressive investments.

• Attitudes towards certain investments – experience, good and bad, can have an influence on the investor’s desire or willingness to include specific securities in their portfolio. Confirm those parameters and explain the implication. Sample statements might include something like:

Due to the past unfavourable experience you had personally investing in speculative junior stocks, you wish to exclude them from your portfolio entirely. Your preference would be to choose a professionally managed fund that only invests well-established companies.

OR

You have had considerable success personally investing in real estate and always want to have a portion of your portfolio allocated to that asset class. However, as you no longer have the time to personally choose the specific properties, you would like to own a mutual fund that has a good, diversified portfolio of commercial and residential holdings.

• Degree of belief in “buy and hold” vs. “market timing” – the extent to which an investor prefers a long-term vs. “get-rich-quick” approach will have an influence on the securities recommended. For example, an investor who likes to “play the market’ using short-term trading tactics will be less likely to retain a large cap segregated or mutual fund with low stock turnover, particularly in times of dramatic market upswings. Confirm the client’s attitude and explain the implications. Sample statements might include something like:

During our discussions you described the thrill you have gotten in the past from trading stocks for a quick profit. While you recognize that you cannot manage your entire portfolio that way, you do want to have access to some of your money on short notice to take advantage of any opportunities you see.

OR

Your past attempts to “time the market” have been less than successful. As a consequence, you have concluded that a longer-term “buy and hold” approach is more likely to meet your needs. This does not imply that we will not regularly review the investment choices made. Adjustments, as required to keep on the original track, will be made periodically.

• Willingness/interest/ability to be involved in the decision-making process – some investors are very keen to take an active role in the management of their portfolio while others prefer to leave most of the decisions to their trusted advisor. In addition to implications for security selection, understanding the client’s attitude with respect to their level of involvement will also help determine their service and communication needs. Sample statements might include something like:

While you are not in any way abdicating responsibility for the decisions around your investments, you have indicated you want to carefully choose a good portfolio of appropriate segregated or mutual funds that are compatible with your long-term objectives. We will review the selection on an annual basis to confirm your progress.

OR

As you have a very keen interest in what is happening in the investment markets, you want to have regular communication with your advisor with a possible view to re-aligning the portfolio in light of changing conditions.

2. Restate the client’s primary and secondary investment objectives

• Growth – most clients will have some element of growth as one of their investment objectives, even if they are retired and living on income from their investments. The impact of inflation through the retirement period will normally dictate that a portion of the investment strategy be dedicated to keeping pace with increases in the cost of living. Sample statements might include something like:

At this particular stage in your life, your most important investment objective is to increase the value of your portfolio so that when you reach the day of retirement you will be able to enjoy the standard of living you have set for you and your family.

OR

While having a steady income from your portfolio is the most important objective for you now, you also recognize that we must structure your portfolio in such a way that it continues to grow in value to offset the impact of inflation through your retirement years.

• Income – clients at or near retirement will normally have a greater interest in generating income than those investors who are many years away from retirement, although this is certainly not always the case. Some investors may require income to meet current debt or cashflow obligations while they simultaneously seek to increase the overall value of their portfolio. Sample statements might include something like:

The most important investment objective for you as you approach retirement is to be assured of a consistent income from your portfolio to supplement your pension and government benefits.

OR

While generating an income from your portfolio is not the highest priority, you do wish to receive a monthly income over the next three years to assist with your children’s education costs.

• Liquidity – unless a client has access to immediate cash from some other source, they may wish to have some portion of their portfolio available on short notice and without severe penalty, such as deferred sales charges or interest adjustments. This will permit them to deal with emergencies or opportunities as they arise. Other clients may want their portfolio in more liquid form as they plan to distribute it to others in some fashion other than specific securities. Sample statements might include something like:

While not a priority, you have indicated that you would like to have 5 – 10% of you portfolio available in cash-type holdings to handle emergencies or take advantage of opportunities as they come along.

OR

As part of your planning for the ultimate distribution of your estate, you would like to have a significant portion of your portfolio in liquid assets to facilitate an easy transfer to your heirs.

3. Describe how the asset allocation chosen fits with #1 and #2 above

• Equity assets for growth – in general, equity assets have generated the highest long-term returns. Portfolios with a focus on growth are, therefore, likely to include a significant portion allocated to equities. As noted previously, however, growth may also be a secondary objective. Sample statements might include something like:

As we have agreed that your primary objective is to have your portfolio increase in value up to the day you retire, we have allocated 60% of your portfolio to equity-type assets, which have shown the highest historical long-term returns of all the asset classes.

OR

While growth is not the primary focus of your investment needs at this time, we have agreed to allocate up to 20% of your portfolio to equity-type assets for their ability to offset increase in the cost of living.

• Debt-type assets for income – fixed income assets such as bonds, mortgages, etc. generally are structured in such a way as to offer the greatest ease of income generation (taxation, etc. notwithstanding). Other assets such as growth oriented segregated or mutual funds can also be used to advantage under an automatic withdrawal plan or on an annuity basis to provide income. Sample statements might include something like:

Given that your highest priority is to be confident of receiving a steady income from your investments, we have agreed to allocate approximately 70% of your portfolio to income producing assets such as bonds, mortgages and annuities

OR

In order to provide the monthly income you require over the next three years, we have allocated 30% of your portfolio to funds that have a track record of making regular distributions consistent with your needs.

• Cash assets for liquidity – bank accounts, short-term deposits, Treasury Bills, money market accounts, etc. can all be used to meet cash needs on demand. Many clients will have adequate credit facilities to handle most emergencies but will still appreciate the peace of mind that comes from having access to some portion of their portfolio, if required. Sample statements might include something like:

To provide you with a cash reserve, we have allocated 10% of your portfolio to short-term instruments and deposit accounts

OR

You have indicated that you have an excellent relationship with your bank and obtaining credit in the event of an emergency or opportunity will not be a problem. Nevertheless, you have expressed a desire to keep up to 10% of your total portfolio relatively accessible in a short-term guaranteed investment.

4. Describe and justify types of securities being recommended

• Equity – stocks, segregated and mutual funds, real estate, commodities, collectibles, etc. – equity-type investments have historically shown the highest long-term returns with the greatest short-term volatility. Illustrate both the annual and cumulative results over the past years (as far back as possible) so that the client can appreciate the trade-off between short-term fluctuation and long-term growth. Sample statements might include something like:

Based on data going back over 50 years, Canadian stocks have averaged approximately 8% compound return with a range typically falling between 0% and 18% on a five year basis. There have, however, been years when they have declined by more than 50% and five-year periods when there has been virtually no gain. While we know that past results are no indication of future returns, they are the best guide we have to what we can expect, particularly relative to other asset classes. Given your objectives and tolerance for fluctuation in your portfolio value, a weighting of 60% in Canadian equities appears to be appropriate. Consequently, we are recommending a Canadian growth segregated fund with a long-term track record that parallels the market itself. It also provides some guarantees with respect to your invested capital that will make it consistent with your risk tolerance.

OR

While the real estate market has proven to be volatile on an annual basis, it has shown itself to have a very low correlation of returns to other equity-type investments. This means that as the others decline, real estate is typically (but not always) increasing in value. Finding investments that excel at different times is one of the keys to successful investing so that declines in one security are offset by increases in another. For this reason, we are recommending that 10% of your portfolio be allocated to a real estate mutual fund.

• Debt – bonds, GICs, term deposits, segregated and mutual funds, mortgages, etc. – on an overall asset class basis, fixed income or debt-type securities have provided the second highest average returns with the second highest volatility. Many portfolios will contain debt assets to provide income or as a hedge against the volatility of equity assets. Sample statements might include something like:

To provide you with a source of income from your portfolio, we are recommending a high yield bond mutual fund that has a consistent record of interest payments. While slightly more aggressive than, for example, a government bond fund, this type of fund has shown higher returns with little incremental risk because it invests only in the debt securities of large Canadian and US companies.

OR

To ensure that you receive an income of $2000/month from your portfolio for as long as you live, we are recommending an annuity with payments guaranteed for your life or a minimum of 10 years should you die before 10 years of income have been received.

• Cash – bank accounts, T-Bills, money market funds, cash accounts – the determining factors will be expected frequency of access, ease of completing the transaction, penalties (if any) and client familiarity and comfort. Sample statements might include something like:

To meet your short-term cash requirements, we are recommending the use of a money market mutual fund. While the returns are not high on this type of investment, they exceed those available in a bank and yet you can access your money within a day or two, if required.

OR

You have indicated that while you desire access to cash if required, you do not expect that to be very frequent, if at all. For these reasons, we are suggesting the purchase of a Government of Canada 91-Day Treasury Bill, which can be cashed at any time or reinvested every three months to match current interest rates.

5. Identify specific securities that meet criteria in #3 and #4 above – use whatever data source is available to describe the features of the specific securities being offered.

• For cash investments, show the range of rates presently available for deposit accounts, T-Bills, money market funds, etc. and place your recommendation in order of its return expectation. Sample statements might include something like:

Government of Canada 91Day T-Bills are presently offering 3.4%. This is up 0.25% from the previous issue but down from last year’s high of 4.5%. This rate is approximately 1.5% better than what is available in a bank account.

• For debt assets, show the range of returns presently available on bonds, term deposits, mortgages, etc. and place your recommendation in order of its return expectation. Sample statements might include something like:

The present yield on Government of Canada 2015 bonds is 6.5%. This represents the return if held to maturity but could increase or decrease due to fluctuations in interest rates if sold prior to that date. The 2015 series of bonds is considered mid-term in duration and as such, strike a compromise between short and long-term interest rates.

• For equity assets, show the year-by-year and historical returns for the industry or sector and compare the specific security being recommended to its peers. Sample statements might include something like:

During the recent general market downturn, the one sector that remained positive was ______ with a return last year of 6.5%, bringing the 5-year average to 7.8% with only one negative year. XYZ Corp is one of the leading companies in this sector and it’s individual results were 7.2% last year leading to a 5-year average of 9.6%, with no negative years.