Challenge Pathway -Prep Book

Treynor Ratio Examples : If an investment’s return is 10% with a beta of 0.85 with an available risk-free rate of 3%, the Treynor is .6364. When comparing investments based on this ratio, the higher the number the better the return/risk relationship for the investor. The Treynor ratio can be used to compare different portfolios, funds or securities (provided they are of a similar nature to allow for reasonable comparison). Comparing 2 Funds : All other factors being equal, Fund 2 would be the better choice based on the Treynor ratio, because it produced more return per unit of risk that was taken. When comparing investments based on this ratio, the higher the number the better the return/risk relationship for the investor International College of Financial Planning – Challenge Pathway Prep Book Page 97

Jensen Index Unlike the Sharpe and Treynor ratios, which are relative measures of performance, alpha is an absolute measure of performance, meaning that it can be used by itself. The simplest description of Jensen’s alpha (or index) is that it measures the difference between an investment’s actual returns and those that could have been earned by its benchmark, with a comparable beta. Capital asset pricing model The Jensen index uses the capital asset pricing model (CAPM), covered later, as the basis of its measurement. Benchmark Construction and Comparisons  In addition to comparing returns of potential holdings against one another, or how they performed on a risk-adjusted basis, investors also commonly want to know how their investments performed relative to the market.  Performance evaluation of a fund or manager looks not only at the absolute returns the returns relative to a benchmark. As we saw previously, performance in excess of a benchmark or required rate of return is alpha. Another important aspect to pay attention to is the method used to weight the securities that make up a given index. While there are variations on the calculation of weighting methods, the three most common methods are by market capitalization, price, or equal weighting. Market Capitalization (Value) Weighted Index-In a market capitalization-weighted or cap-weighted index, each security is maintained in the index at a percentage weighting equal to the percentage International College of Financial Planning – Challenge Pathway Prep Book Page 98

capitalization (total # shares outstanding x current price per share) that it represents of the index’s total market capitalization. Price Weighted Index-As the name indicates, in a price weighted index, the current market price of a company’s stock, not its market capitalization, determines how much of the index a single security accounts for. The higher a security’s price, the more impact it has on the price of the index, regardless of its total market value. Equally Weighted Index-Equally weighted indexes give equal rating to all the components of an index, regardless of the current stock price or total market capitalization. In an equally weighted index, it is the percentage change in price of each component that is aggregated to determine the index’s current price/value. Benchmark Construction and Comparisons The performance evaluation process includes four stages. 1. Measuring absolute returns Absolute returns are the returns achieved over a certain time period. 2. Adjusting return for risk Investors prefer higher returns, but lower risk. 3. By measuring relative to a benchmark investors can assess performance of a fund or manager. ng relative returns By measuring relative to a benchmark investors can assess performance of a fund or manager. 4. Attributing performance International College of Financial Planning – Challenge Pathway Prep Book Page 99

Determine how much of performance is the result of the selection of asset classes, sectors, individual securities, and currencies. Fundamental Analysis  Fundamental analysis involves the examination of financial fundamentals (sales, earnings, net income, etc.) to attempt to predict the future performance of a company.  It includes analyzing and interpreting various financial statements and the outcomes of decisions made.  Fundamental analysis involves the formulation of forecasts to estimate the intrinsic value.  Buy and sell decisions are made on whether the current market price is less than or greater than the estimated intrinsic value. Top Down Method of Fundamental Analysis (Economy- Industry – Company) In the top-down method, an investor tries to identify broad economic trends and then selects industries and companies that should prosper from a given trend. The economy: Especially in the three areas listed below: A. Business cycles: Long-term business cycles tend to go through four phases: 1. Expansion or recovery 2. Peak 3. Contraction or recession (or even depression if the cycle drops low enough) 4. Trough B. Central bank monetary policy: Policy loosens during periods of recession to spur growth (i.e., the growth rate in the money supply expands), while policy tightens during periods of growth to combat inflation (i.e., the growth rate in the money supply contracts). The most commonly used tool of central banks to alter monetary policy is changing the rate at which banks borrow reserves from each other. International College of Financial Planning – Challenge Pathway Prep Book Page 100

C. Fiscal policy: This refers to whether the government is increasing or decreasing spending and/or whether the government is increasing or decreasing taxes. The industry: To determine which industries are likely to do well during the current economic environment; the three basic types of industrial classifications exist: A. Defensive: Those companies that are least affected by business cycles, usually firms producing nondurable consumer goods (e.g., utilities, beverage companies, grocery chains, etc.). B. Cyclical: Very vulnerable to business cycles (opposite of defensive), usually firms producing durable goods (e.g., heavy equipment, capital goods, raw materials, etc.). C. Growth: Firms growing faster than the economy because of product developments or technological changes. The company: To determine which companies within selected industries offer the best investment opportunities, companies are primarily evaluated in four areas: A. Competitive position B. Prospects for growth and stability C. Management ability and integrity D. Current financial position (evaluating financial statements using ratio analysis) Bottom-Up Analysis (Company – Industry – Economy ) Bottom-up investing takes a micro approach. A bottom-up analyst concentrates on the company’s fundamentals and gives secondary or little attention to analyzing the industry or economy. The idea is that stock pickers can find companies that will do well over time on their own merits, unaffected by market or industry trends. International College of Financial Planning – Challenge Pathway Prep Book Page 101

The goal of a bottom-up analysis is to gain a detailed understanding of the company itself, including its products, services and management approach. Technical Analysis -Technical analysis focuses on the analysis of the patterns and direction in price movement of a company’s stock, rather than on the fundamental information about the company itself. -We could best describe technical analysis by saying, “the trend is your friend.” This means technicians chart price movements, volume data, and changes of direction in both, to learn something about the future direction of the market and individual securities. Technicians use charts to do their analysis. These charts can, and do, show many aspects of market activity, but regardless of the chart, technicians usually ask four questions: 1. What is the overall trend? This involves analysis of moving averages over select periods of time (e.g., 50 days, 200 days, etc.) to determine the direction (e.g., up, down or sideways) of the trend. Movement above the trend line is generally considered positive (i.e., bullish), while movement below is considered negative (i.e., bearish). 2. Is there a support level? Support levels are areas where prices are clustered below the current price level. A drop below support indicates a bearish move. 3. Conversely, is there a resistance level? Whereas support is at the bottom of a trend line, resistance is at the top (think “floor” and “ceiling”). Resistance reflects the stock’s price hitting a level, but not going higher. A break through resistance (to the topside) is considered bullish. 4. What is the momentum, or what is the trend? This is a look at a recent series of price movements (i.e., moving averages) to see whether they are trending up, down or sideways. Momentum also looks at trading volume to determine the rate of change. A bullish trend occurs when a short-term trend line passes above a long-term line, especially with good volume (and bearish in the reverse). International College of Financial Planning – Challenge Pathway Prep Book Page 102

Technical Analysis: Price and Volume-Based Rules Technical analysts also use price and volume trends to establish trading rules and strategies, such as: 1. Moving averages 2. Charting 3. Support and Resistance Levels 4. Relative Strength Contrarian Investing Rules/Strategies Investors who identify themselves as contrarians believe that most investors are incorrect in their investment decisions, and will therefore take investment action that is opposite of what the majority is doing. Some of the technical trading rules used by contrarians include: 1. Odd-lot theory 2. Cash positions in mutual funds 3. Put/Call ratio 4. Short interest 5. 200-day moving average 6. Advance/decline line Investment Theory Explain the assumptions of Modern Portfolio Theory (MPT) The thrust of MPT, in part, is that portfolio assets should be selected based on how they interact within the portfolio, rather than only on an asset-by-asset basis. MPT attempts to identify how to build a portfolio with the highest possible return for a given amount of risk (i.e., mean-variance optimization). International College of Financial Planning – Challenge Pathway Prep Book Page 103

Assumptions o Investors are rational, and want to realize the best possible utility (satisfaction) of their investments. o Investors prefer the lowest level of risk, and for a given level of risk, want the maximum possible return. o When making decisions, investors consider only risk and return. o Risk is represented by standard deviation (variance). o Investors have full access to all relevant investment information. o An investor cannot manipulate, or take advantage of, the market, because it is perfectly competitive. One of MPT’s assumptions is that investors are looking for the highest reasonable return for a given level of risk. In MPT, a limited number of combinations occur that maximize return for a given risk level. If we charted the line (a parabola) for these optimal risk-return combinations, we would have what MPT calls the efficient frontier. As a simple way to understand the efficient frontier, we can say that no portfolio could achieve a higher return without taking on more risk. The two portfolios labeled on the efficient frontier line represent the maximum expected return for two given levels of risk. The investor cannot build an attainable portfolio above the line, and any portfolio below the line is not as efficient (e.g., the low risk portfolio shown). Understand that neither efficient portfolio is technically better or more efficient than the other. Both are equally efficient. One maximizes return for one level of risk, while the other does the same for another level of risk. One method that an investor can use to determine the optimal portfolio incorporates indifference or utility curves. An indifference curve attempts to balance risk and return, and measures the investor’s preferences in finding the balance along the efficient frontier. Capital Asset Pricing Model (CAPM) -William Sharpe (who received the 1990 Nobel Prize along with Markowitz) focused on how to price (risky) assets. His major work is the capital asset pricing model (CAPM). International College of Financial Planning – Challenge Pathway Prep Book Page 104

-Using CAPM, an investment advisor can determine a required rate of return for any risky asset (as opposed to a riskless asset, e.g., Treasury bill). -CAPM has two divisions, the broader version focusing on the overall capital market, called the capital market line (CML), and the narrower version focusing on individual securities, called the security market line (SML). If we now drew a line from the 5% risk-free spot and made it tangent to the efficient frontier the spot where it touches the line is called the market portfolio. This is called the capital market line. The capital market line (CML) assumes that a risk-free asset exists. That is, an investor can purchase an asset that has no uncertainty about the expected rate of return. International College of Financial Planning – Challenge Pathway Prep Book Page 105

Capital Asset Pricing Model (CAPM) -The standard deviation of the two-asset portfolio with a risky asset is the weight of the risky assets in the portfolio multiplied by the standard deviation of the portfolio. -The line connecting the two portfolios becomes a straight line International College of Financial Planning – Challenge Pathway Prep Book Page 106

CAPM gives us the required rate of return. But where did the expected price of the stock in one year come from, and therefore the forecasted expected return? These figures were provided for the example. The stock return estimates would come from single security intrinsic valuation analysis. The equity investment valuation models are: 1. Dividend Discount Model Valuation 2. Free Cash Flow Valuation (Free Cash flow to Equity or Firm) 3. Market Based Valuation: Price and Enterprise Valuation multiples International College of Financial Planning – Challenge Pathway Prep Book Page 107

The foundation for stock security selection is therefore the comparison between the required rate of return and the expected returns. Note that many of these calculations are based on estimates and forecasts. Efficient Market Hypothesis (EMH) Fama, in his Ph.D. dissertation, stated that at any given time and in a liquid market, security prices fully reflect all available information. Fama’s hypothesis is known as the efficient market hypothesis (EMH). As this hypothesis evolved, Fama said that, to test its validity, EMH could be divided into three forms: 1. Weak: Assumes that current stock prices reflect all available (current and historical) stock market information. Under the weak form of the EMH, past price and volume data of a stock have no impact on the future direction of the stock’s price. If the weak form is true, it follows that technical analysis is not beneficial, since it adds no predictive value. 2. Semi-Strong: Assumes that new information available to the public is immediately factored into stock prices, and can be used by investors. The market then regains equilibrium. If true, the semi- strong form effectively discounts fundamental analysis. 3. Strong: Assumes current stock prices fully reflect all public and nonpublic (including insider) information (i.e., a perfect market). That information is available to all investors; therefore, one cannot use such information to consistently achieve excess returns. 1. If markets are weak-form efficient, technical analysis is useless. 2. If markets are semi-strong-form efficient, both fundamental and technical analysis are useless. 3. Evidence supports both weak-form and semi-strong-form efficiency. 4. Markets are not strong-form efficient.---Impossible – includes private information Asset Allocation Asset allocation is the process of distributing portfolio investments among different asset classes, such as money market instruments, bonds, stocks, real estate and commodities. International College of Financial Planning – Challenge Pathway Prep Book Page 108

The asset allocation decision has a profound impact on the long-term results from a portfolio, so this decision deserves attention. Furthermore, asset allocation is important in investing because the asset allocation of a portfolio determines its risk/return characteristics. The process involves two main decisions: 1. Which asset classes will be included or excluded from an investor’s portfolio. 2. the portfolio will be weighted among the asset classes chosen for the portfolio. Asset Allocation Strategies The investment advisor has several asset allocation strategy types from which to choose. Broadly, asset allocation approaches include: The asset allocation decision has a profound impact on the long-term results from a portfolio, so this decision deserves attention. Furthermore, asset allocation is important in investing because the asset allocation of a portfolio determines its risk/return characteristics. The process involves two main decisions: 1. Which asset classes will be included or excluded from an investor’s portfolio. 2. How the portfolio will be weighted among the asset classes chosen for the portfolio. Strategic Allocation Strategic asset allocation focuses on selecting a mix of different asset classes, assigning a target weighting (percentage of total portfolio) and rebalancing on a regular basis (at least annually). Once the investor determines the asset mix and the percentages (e.g., 60% stocks, 30% bonds and 10% cash equivalents), the intention is to maintain the balance within the portfolio within an acceptable range. The selection and weighting of asset classes is guided by modern portfolio theory and the creation of the optimal portfolio for each client. International College of Financial Planning – Challenge Pathway Prep Book Page 109

-Long-term -Generally, passive once the asset mix has been chosen -Rebalanced periodically to return to the original allocation percentages 1. Seeks to identify and maintain a portfolio asset allocation appropriate for an investor’s financial goals, investment objective, time horizon, and volatility tolerance; 2. Makes no attempt to predict the direction or magnitude of short-term market volatility; 3. Is characterized by a fixed target allocation to each asset class in an investor’s portfolio; and 4. Requires periodic portfolio rebalancing in order to maintain the target allocation to each asset class. Strategic asset allocation is, therefore, not a buy-and-hold strategy. Tactical Allocation Tactical asset allocation also involves allocating across different asset classes and rebalancing, but it differs from strategic asset allocation in that it attempts to predict which asset classes (or individual securities) will be the next to have gains/outperform other asset classes in the short term. Funds are then allocated to those asset classes in anticipation of future gains. This strategy boils down to security selection and market timing, and is practiced despite significant evidence that successfully timing the markets (or securities trading) is extremely difficult, if not impossible, to do on a consistent basis over time. -Shorter-term (than that for strategic allocation) -Responds to changes in the market(s) -Can involve market timing and sector rotation Core/satellite Allocation This approach has gained more acceptance in recent years from investment advisors. It is a combination of strategic and tactical asset allocation achieved by dividing a portfolio into a core International College of Financial Planning – Challenge Pathway Prep Book Page 110

holding of strategically allocated assets (often in low-cost, broad-based index collective investments or broad-based exchange-traded funds). This core typically represents 70–80% of the total portfolio, and is maintained at the prescribed allocation through periodic rebalancing. The remaining 20-30% of the portfolio is the satellite portion and is allocated to a tactical strategy (active management) to capture some excess gains (alpha). -Generally, strategic allocation with a tactical overlay -Strategic allocation is the largest portion (e.g., 80%) -Core often invested passively in index funds to get broad market exposure (beta) -Satellite actively invested to take advantage of market opportunities (alpha) Dynamic Allocation Dynamic asset allocation is used primarily by institutional investors. As a result, other than knowing it exists, there is not much need for the average investment advisor to delve too deeply into its inner workings. This type of allocation is used primarily to hedge a portfolio against big declines in value. To do this, the investment manager will shift between riskless and risky assets, making the changes in response to what is happening in the marketplace. As portfolio values change, the allocation will change with it. You can understand how this requires more-or-less constant oversight, which is something institutional investors have the ability to do. International College of Financial Planning – Challenge Pathway Prep Book Page 111

Rebalancing Strategies Once an investor has determined an appropriate asset allocation, the portfolio will require periodic rebalancing to maintain its original focus and intention. Why? Over time, some assets will grow while others will shrink, based on market returns. The goal will be to bring the portfolio back to its desired allocation. This probably will mean selling some assets that have shown strong growth and purchasing others that have not done as well. Rebalancing is primarily about risk control, or making sure the portfolio isn’t overly dependent on the success or failure of one investment, asset class, or style. Time-Based Rebalancing This time-honored approach requires revising the portfolio asset allocation on a predetermined schedule. This could be every six months, every year, or some other time. Many investment professionals suggest rebalancing the portfolio once annually. International College of Financial Planning – Challenge Pathway Prep Book Page 112

While this may be beneficial, it may also mean increased portfolio expenses and potential taxes from realizing gains. It may also cause sales or purchases of assets that don’t need to be sold or bought at the time, or at least so frequently. Threshold-Based Using this approach will require focusing on the degree to which assets in the portfolio have increased or decreased in value and, thereby, increased or decreased as a percentage of the portfolio. Assume one asset has gained 15% in value while another has lost 15% in value. You can do an even swap and immediately bring the asset allocation back into balance. It’s not likely you will see such a clean increase/decrease scenario, so you will have to make some decisions about what to adjust and by how much. Time and Threshold-Based A reasonable approach is to evaluate the portfolio annually. When doing so, you may find that you don’t need to make any changes. If this is the case, don’t force a rebalance. However, after your evaluation, you may determine at least some investments have moved from the target allocation, and by more than you want to see. Active Management We looked at Jensen’s alpha, and how to determine the degree to which an asset manager is adding value to the portfolio. The consideration of alpha brings us to the next portfolio decision: active or passive management. Active management, as the name implies, involves actively selecting securities based on the belief that doing so will allow the asset manager to achieve higher returns (after fees) than those produced by the market. In many cases, the results do not support the active manager’s fees. Sometimes, however, they do. Some managers, either consistently or for a time, can generate higher returns. International College of Financial Planning – Challenge Pathway Prep Book Page 113

Those who disagree with active management cite a large body of research showing that active management frequently fails to produce higher returns, and may expose the individual to increased investment risk. Therefore, why pay the associated fees and submit to the potential for increased risk? This debate continues, with little sign of slowing, and we will not enter into it here except to say that research has shown both sides to be both right and wrong. Passive Management  Does not have to constantly work to produce excess returns and/or minimize risk, only to consistently fail at one or the other  If the EMH is correct, it’s nearly (or fully) impossible to beat the market  The past does not repeat itself, therefore, active managers have no real basis for their work  Very few active managers have proven to be regularly successful. Among the few: Warren Buffett, Peter Lynch (former manager of Fidelity’s Magellan fund), Sir John Templeton (global money manager) and John Neff (Wellington Fund).  Passive management generates lower fees than active management  Fewer security sales in the portfolio keeps the tax bill lower Charles Ellis, in his article, \"Three Ways to Succeed as an Investor\", outlines three approaches of investing. 1. The Intellectually Difficult Approach 2. The Physically Difficult Approach 3. The Psychologically Difficult Approach Intellectually difficult investing is pursued by those who have a deep and profound understanding of the true nature of investing, see the future more clearly, and take long-term positions that turn out to be remarkably successful. International College of Financial Planning – Challenge Pathway Prep Book Page 114

Most of the crowd is deeply involved in the physically difficult way of beating the market. In every way they can, they put enormous energy into trying to beat the market by outworking the competition. What they don’t seem to recognize is that so is almost everyone else. Being incapable of doing the intellectually difficult, and reluctant about the physically difficult, I have set about the emotionally difficult approach to investing. This straightforward, untiring approach is simply to work out the long-term investment policy that’s truly right for you and your particular circumstances and is realistic given the history of the capital markets, commit to it, and - here is the emotionally difficult part – hold on. Active Versus Passive Management Which is better? The simple answer is a passive investing approach will likely generate market-level returns with lower fees and expenses. However, if you, or the asset manager you use can generate better-than-market returns, active management, at least in part, may make sense. In other words, you and the client must decide and from time-to-time revisit the decision. In his best-selling book, \"One Up On Wall Street\", Peter Lynch, one of the most successful money managers of the last 50-plus years, offers some worthwhile suggestions for portfolio design. Among his suggestions are: 1. Keep return expectations realistic (neither too high nor too low). 2. If the best you can do is match market performance, buy index funds. 3. Long-term investing is generally more effective and efficient than short-term trading. 4. Adapt the portfolio to changing client requirements, as necessary. Most of Mr. Lynch’s suggestions are common sense, but sometimes it seems that common sense in investing is not always so common. International College of Financial Planning – Challenge Pathway Prep Book Page 115

Wealth Management The term wealth management has no precise definition but has been generally described as the ability of an investment advisor (or advisory team) to deliver a full range of financial services and products to an affluent client in a consultative way. Generally, wealth management combines the services of financial and investment advice, accounting and tax services, retirement planning and legal or estate planning. Wealth management professionals can offer their clients products and services that are not necessarily investment oriented. A competent wealth manager must be conversant with all component areas that impact a person’s wealth or financial well-being. These components include: 1. Principles, Process, and Skills 2. Financial Management 3. Tax Principles and Optimization 4. Investment Planning/Asset Management 5. Risk Management and Insurance Planning 6. Retirement Planning 7. Estate Planning and Wealth Transfer 8. Integrated Wealth Management (i.e., putting it all together) International College of Financial Planning – Challenge Pathway Prep Book Page 116

Add the term financial planning to the first component and the last, and you will have the eight core component areas of financial planning. It is also useful to look at a common framework for the financial phases of life. The four financial phases of life are: 1. Accumulation of wealth; 2. Protecting wealth; 3. Converting wealth to income; 4. Transferring wealth. The four financial phases of wealth management match up well with the financial planning competency areas. International College of Financial Planning – Challenge Pathway Prep Book Page 117

As we can see from the integrated nature of financial planning and wealth management, it is often necessary to engage the advice or use of the services of other professionals in order to execute the recommendations of the plan. Three professional teamwork and collaboration skills highlight that is important that a financial planner: 1. Recognizes when to refer to qualified professionals to provide the necessary expertise; 2. Works with other professionals, as appropriate, to help implement the financial plan; 3. Co-ordinates and manages client interactions with other qualified professionals as needed. Process is one of the fundamental tenets of wealth management. A medical doctor follows a process flowing from intake, through examination and evaluation, to diagnosis and recommendation and/or treatment. In the same way, a wealth manager follows a process to be effective and efficient in serving clients. Wealth management shares the same six steps as the financial planning process: 1. Establish and define the relationship with the client 2. Collect the client’s information 3. Analyze and assess the client’s financial status 4. Develop the recommendations and present them to the client 5. Implement the client’s recommendations 6. Review and monitor the client’s situation International College of Financial Planning – Challenge Pathway Prep Book Page 118

Concentrated Investment Holdings For many individuals, the biggest asset they own is their house. This may not be the case for owners of privately held companies where the value of their ownership is their most valuable asset. It is therefore important for a financial planner or wealth manager to have some basic understanding of business valuation and the ownership succession process. An owner selling their business often represents a significant liquidity event that requires an integrated planning approach. Individuals and Families may have concentrated investment holding due to two reasons: 1. Large ownership percentage or value of a private company; 2. Large value of ownership in an employer public company through stock savings or options. A text titled “Exit Strategies for Business Owners” lists five key points on preparing for ownership succession. 1. Begin the process early, ideally 2 or more years prior to sale or succession. 2. Be aware of the ownership succession alternatives that are available, and carefully consider the pros and cons of each. Succession alternatives include a transition of the company to family members, a sale to management, or a sale to financial investors or a strategic buyer. 3. Recognize the personal, company, and environmental factors that influence the ideal timing for ownership succession. 4. Undertake operational and financial structuring to make the company attractive to prospective buyers and realize on additional sources of value. 5. Structure personal and business affairs to help ensure a tax-efficient transition. International College of Financial Planning – Challenge Pathway Prep Book Page 119

Financial Ratios from a Company Balance Sheet Financial statement ratios are useful as a quick way to compare an aspect of one business with others like it. Ratio analysis can be classified under four major headings: 1. Liquidity ratios, such as the current ratio and quick ratio, determine whether a company can meet its obligations as they come due. 2. Activity ratios, such as accounts receivable turnover and inventory turnover, determine how rapidly assets move through the company, including how quickly inventory is moving out the door, and how quickly payments are received. 3. Profitability ratios, such as EBITDA (earnings before income taxes, depreciation and amortization), return on capital and return on equity (ROE) measure performance and how profitable the company is, and what sort of return the company is getting on capital and equity. 4. Leverage ratios, such as debt-to-equity and debt-to-capital, measure the extent to which a company uses debt financing. Assets on a Balance Sheet International College of Financial Planning – Challenge Pathway Prep Book Page 120

Income Statement 1. Liquidity Ratios 2. Activity Ratios International College of Financial Planning – Challenge Pathway Prep Book Page 121

3. Profitability Ratios Profit margin ratios. Three profit margin ratios are most commonly used. In each ratio, net sales is in the denominator, the numerator is : 1) gross profit (gross profit margin), 2) operating profit (operating profit margin) and 3) net profit (net profit margin). EBIT and EBITDA The terms EBIT and EBITDA have become popular in recent years. EBIT (earnings before interest and taxes) can be considered equivalent to operating profit margin. EBITDA (earnings before interest, taxes, depreciation and amortization) can be considered equivalent to cash flow from operations. The steps to calculate EBITDA: 1. begin with income before taxes as reported; 2. add back depreciation and amortization, as these are non-cash items; 3. add back (deduct) other non-cash items such as losses (gains) on the sale of fixed assets; 4. add back interest expense. The enterprise value of a business is determined on a ‘debt free’ basis, and therefore interest is added back; International College of Financial Planning – Challenge Pathway Prep Book Page 122

5. add back (deduct) unusual or non-recurring expense (income) items; Assume the following for Company ABC: -pretax income reported at £3.2 million in the most recent fiscal year which is likely for future years; -interest expense reported at £800,000 and depreciation and amortization of £2 million; -£10 million of interest-bearing debt outstanding. -Assume that following an analysis of Company ABC’s operations, risks and growth prospects, an EBITDA multiple of 5x is considered appropriate. Calculate the shareholder value using the multiple of EBITDA methodology for business valuation. Return on Equity Ratios 4. Leverage Ratios Leverage ratios (also known as capitalization ratios) show the percentage of total capitalization (debt plus equity) that is debt. Several ratios are used, but the ones that analysts watch most closely are the debt-to-total-capital and the debt-to-equity ratios. International College of Financial Planning – Challenge Pathway Prep Book Page 123

Long-term debt is used in the numerator because it is not paid off during a normal operating cycle. Therefore, it can be manageable today, assuming a favorable business environment, but it could become a burden when the business cycle changes direction. Various terms are used in the figure in the denominator, causing confusion among users of the ratio. The most straightforward description for the figure in the denominator is total capital, long-term debt plus shareholders’ equity. Discounted Cash Flows Cash flow is defined in different ways. The most basic definition might be EBITDA, which was described previously. EBITDA includes operating income after all cash expenses excluding income taxes (not under the control of management) and interest expense (a financing decision, not an operating decision). EBITDA is a look at cash generated from operating the business. The mechanics of a discounted cash flow methodology (DCF) can be quite complicated, but in basic form, the DCF methodology consists of 6 steps: 1. forecast the discretionary cash flow that a company is expected to generate in each of the next few years, generally three to five years. To calculate discretionary cash flow: International College of Financial Planning – Challenge Pathway Prep Book Page 124

Earnings before interest and taxes (‘EBIT’) - cash income taxes = net income before financing costs + depreciation and amortization - capital expenditure requirements - incremental working capital required to support growth = discretionary cash flow 2. the discretionary cash flow for each year of the forecast period is discounted to a present value amount using a discount rate. The discount rate represents the required rate of return for a particular investment opportunity given the associated risks.● 3. a ‘terminal value’ is calculated by estimating the annual discretionary cash flow beyond the forecast period, divided by a capitalization rate. The capitalization rate represents the discount rate less a long-term growth factor. The terminal value represents the estimated enterprise value of the company beyond the forecast period. 4. the terminal value is discounted to a present value amount using the same discount rate applied to the discretionary cash flows; 5. the present value of the terminal values is added to the present value of the discretionary cash flows to calculate the enterprise value of the company; 6. interest bearing debt is deducted from enterprise value to derive the shareholder value of the company. International College of Financial Planning – Challenge Pathway Prep Book Page 125

Concentrated Investment Holdings Executive Stock Options Similar to private business owners who have their business ownership as a large percentage of their net worth, executives at publicly traded corporations can have as a result of stock options or stock savings plans, a high concentration of their portfolio invested in one company. A common result of incentive stock options, or an executive stock ownership plan, is an increase in the size of the executive’s stock position with the company over time. This means the executive is likely to have some degree of concentration within his or her portfolio of company stock. The question this should raise is whether the concentrated position increases potential portfolio risk to an unacceptable degree. The answer to that question is often yes. If the executive works with, or owns, a smaller company, then the risk may be greater volatility, because smaller company stocks often exhibit that tendency. According to a paper by Morgan Stanley, the first step to address a concentrated stock position is to define strategic objectives, which may include: 1. Creating liquidity 2. Hedging risk 3. Diversifying the concentrated position 4. Accepting the risk of a concentrated position International College of Financial Planning – Challenge Pathway Prep Book Page 126

Alternative Investments for High Net Worth Individuals The use of alternatives opens the portfolio to investment possibilities in asset classes outside of those normally considered to be traditional. Trusts -Advanced tax planning and more complex estate planning issues are often required for high net-worth investors with unique family situations, who are involved with charitable giving or as we saw previously business owners who are planning succession and exit strategies. In these cases, there is often the use of trusts. -A trust is a legal entity created by a party (the trustor, settlor or grantor) who transfers assets to a second party, the trustee. The trustee holds and manages the assets for the benefit of the named beneficiaries of the trust. The beneficiaries are considered to be the beneficial, not legal, owners of the trust assets. The four main types of trusts are: 1. Living (inter vivos): a trust created by the trustor while they are alive. 2. Testamentary: a trust established through a will and which is created when the trustor dies. 3. Revocable: a trust that can be modified or terminated by the trustor after its creation. 4. Irrevocable: a trust that cannot be modified or terminated by the trustor after its creation. Trusts can also be structured to be either fixed or discretionary. 1. A fixed trust specifies the distributions to the beneficiary. For example, three percent of the total assets value at the end of a calendar year may be distributed to the beneficiary. 2. In a discretionary trust, the trustee determines how much to distribute. International College of Financial Planning – Challenge Pathway Prep Book Page 127

Common Reasons for Trusts: 1. Asset Protection; 2. Control; 3. Tax Reduction. Foundations and Endowments -Foundations and endowments are entities created for philanthropic and charitable activities. Foundations are grant-making institutions funded by gifts and investment assets. Endowments are long-term funds owned by operating not-for-profit organizations. -Private or family foundations must distribute income annually for charitable purposes. In contrast to private foundations, endowments are not subject to a specific legally required spending level. Private Banking versus Wealth Management Private banking is an alternative to nonbank services offered to high net worth individuals (HNWIs). Private bankers usually offer investment-related advice and specialized financial solutions. Some of the available services include special access to loans and lines of credit, estate and retirement planning, and access to investment alternatives. Most private banks require a relatively high level of investable assets (e.g., $500,000 and more). Banks also generally provide a high level of privacy and confidentiality to clients. It’s important to recognize that HNWIs have many of the same needs and concerns as those with lesser means. It’s just as important to remember that those needs and concerns often expand beyond the basics into more specialized territory. To effectively serve HNWIs, investment advisors must educate themselves on the special needs and requirements of this market segment. Further, positioning oneself as a wealth manager demands a high level of investment-related acumen, along with significant real- world experience. International College of Financial Planning – Challenge Pathway Prep Book Page 128

Behavioral Finance Behavioral finance can be defined as the science of applying psychology to finance. While traditional finance indicates that markets are efficient and rational, behavioral finance disputes that notion. Behavioral finance suggests that human beings are not always rational and do not always act in a rational manner. We cannot overstate the impact of this on financial markets, and, more specifically, on individual investors. 21 investor biases in three categories: 1. General Behavioral biases (6), 2. Information processing biases (8) and 3. Emotional biases (7) Behavioral Biases Page 129 1. Cognitive dissonance 2. Conservatism 3. Confirmation 4. Representatives 5. Illusion of control 6. Hindsight Information processing Biases 1. Anchoring and adjustment 2. Mental accounting International College of Financial Planning – Challenge Pathway Prep Book

3. Framing 4. Availability 5. Ambiguity aversion 6. Self-attribution 7. Outcome 8. Recency Emotional biases 1. Loss aversion 2. Overconfidence 3. Optimism 4. Self-control 5. Status quo 6. Endowment 7. Regret aversion The Psychology of Money Money often generates strong feelings in people, with the result that not all money-related decisions are rational. As we saw with behavioral biases, the way people feel about money often influences them to make money decisions that are not necessarily in their best interest. To complicate matters, most people are not aware of their biases or money psychology. Hoarders: Enjoy holding on to their money. It may be difficult for them to spend money on luxury or pleasurable items for themselves or loved ones. International College of Financial Planning – Challenge Pathway Prep Book Page 130

Spenders: Use money to buy whatever is assumed to bring pleasure. They may have a hard time saving, budgeting and delaying gratification to meet long-term goals Bingers: Are a combination of hoarders and spenders. They tend to save, and then spend the money all at once. If binging becomes excessive, it can lead to significant overspending and debt. Money Monks: Try to avoid having too much money. They would feel guilty if they received a large amount of money unexpectedly. Avoiders: -Money avoiders tend to avoid performing various everyday money management tasks. They may feel anxious or incompetent about dealing with money. -Risk avoiders often choose safety and security above all else. They don’t like financial surprises and prefer low-risk investments, even if they produce low returns. Amassers: Are overly concerned with keeping large amounts of money at their disposal to spend, save and invest. The desire to have more may negatively impact relationships and life enjoyment. Worriers : Tend to worry excessively about money. They typically want to exercise a great amount of control over their money and may invest large amounts of time doing things such as balancing accounts and ensuring enough money is available. Worriers allow money to become a significant preoccupation. They also may feel that, if they only had more money, they could stop worrying (this is seldom true). Money worriers may also be hoarders and amassers. Risk Takers: Enjoy taking money risks. They like the thrill and adventure of risk-taking. Safety and security, along with much financial advice, feels uncomfortable to many risk takers. Helping Clients to “Behave” Their Way to Success A review of the behavioral biases should lead to the conclusion that the way to help clients behave their way to success is to help them recognize and revise at least some of their core disabling biases. International College of Financial Planning – Challenge Pathway Prep Book Page 131

However, before embarking on such an endeavor, you should know that it is, at best, quite difficult to get people to change even one of their behavioral biases. Part of the reason for this is that most people cannot see or recognize the very biases that are holding them back. They simply cannot acknowledge the problem in themselves. What can you do to help? o If you can get someone to agree to a disciplined investing (and overall money) approach, you may be able to provide the behavioral help they need. o Help the investor to focus on goals. Help the investor to see the value and desirability of achieving those goals. o Create a disciplined approach to asset allocation, investment selection, periodic rebalancing and evaluating progress. o If the client will agree to this approach, along with a disciplined process of infusing new capital into the portfolio mix, they may keep their biases from negatively impacting goal-achievement. o Some advisors also suggest that the individual take a small percentage (e.g., 10%) of their money and use it to make the investments they think will be appropriate. If they limit themselves to this small amount, they will do themselves little or no harm. They may even come out ahead if they choose well. If you can keep clients from making wholesale changes based on unsupported behavioral biases, you can do a world of good for them. Making rational money decisions is not always easy, but it’s always necessary. Investment Objectives Establish & Define the relationship 1.1 Inform the client about financial planning and the six financial planning professional competencies. 1.2 Determine whether the financial planning professional can meet the client's needs. 1.3 Define the scope of the engagement. International College of Financial Planning – Challenge Pathway Prep Book Page 132

Collect Client Information Page 133 2.1 Identify the client’s personal and financial objectives, needs, and priorities. 2.2 Collect quantitative information and documents 2.3 Collect qualitative information. Analyse & Asset Client’s Needs 3.1 Analyze the client’s information. 3.2 Assess the client’s objectives, needs and priorities Develop the Financial Plan 4.1 Identify and evaluate financial planning strategies. 4.2 Develop the financial planning recommendations. 4.3 Present the financial planning recommendations to the client. Implement the Financial Plan 5.1 Agree on implementation responsibilities. 5.2 Identify and present product(s) and service(s) for implementation Review Client’s Situation 6.1 Agree on responsibilities and terms for review of the client's situation. 6.2 Review and re-evaluate the client’s situation. Ethics in Financial Planning: Eight Principles Principle 1: Client First Place the client’s interests first. Principle 2: Integrity Provide professional services with integrity. Principle 3: Objectivity Provide professional services objectively. International College of Financial Planning – Challenge Pathway Prep Book

Principle 4: Fairness Be fair and reasonable in all professional relationships. Disclose and manage conflicts of interest. Principle 5: Professionalism Act in a manner that demonstrates exemplary professional conduct. Principle 6: Competence Maintain the abilities, skills and knowledge necessary to provide professional services competently. Principle 7: Confidentiality Protect the confidentiality of all client information. Principle 8: Diligence Provide professional services diligently. Engaging Investment Clients -For financial professionals, engaging clients isn't about simply acquiring new clients or selling financial products, it’s about taking the time to develop a thorough understanding of a client’s current financial position, hopeful future position, timeline, concerns, behavioral tendencies, risk tolerance, and current level of planning. -Investment clients typically do not have the same level of knowledge and comfort or familiarity surrounding finance and investments as financial professionals do, which is why most will seek out and engage the services of an investment advisor. -Some people do not feel comfortable discussing their finances with others, so having an organized, pre-planned approach to each meeting, along with projecting a professional attitude, should help bring a sense of ease to the process. International College of Financial Planning – Challenge Pathway Prep Book Page 134

-By having an agenda and a list of questions prepared (and possibly printed) ahead of the initial meeting, the time needed to collect factual data is reduced, leaving more time for the discovery process and discussing client objectives, goals, values, needs, etc. The Initial Client Interview When entering into an initial conversation with a prospective client, it is helpful to think of the process as a two-directional interview. Your prospective clients should be interviewing you as much as you are them, to determine whether there is potential for a good working relationship. To get to know your client, you should ask open-ended questions, and spend most of your time listening and clarifying points and responses. Examples of questions you can ask are: o Tell me about yourself and your family o What brings you in today? o What are your expectations of me/us? o How did you hear about me/us? o Have you had previous experience working with a financial professional? o What did you enjoy about the experience? o What did you not enjoy about the experience? o What did you not enjoy about the experience? o What worries you or keeps you awake at night? o What does a good professional-client relationship look like to you? o What are your hopes and dreams? o What are your biggest financial concerns? o What are your biggest nonfinancial concerns? o What do you (and your family) do for fun and relaxation? o What things are most important to you in this world? o Do you tend to have an optimistic or pessimistic view of the future? o If we decide to work together, what would be the top few reasons you would leave? International College of Financial Planning – Challenge Pathway Prep Book Page 135

o What were the best and worst investing experiences you’ve had? Tell me about each one. o When you look at your current situation, what do you feel is working well, and what needs to be improved? o If we do work together, what would need to happen over the next year or two for you to know you made the right choice in working with me/us? Examples of questions clients' can ask are: o How long have you been in the business? o What is your professional and educational background? o Do you have any professional credentials? What are they? o What does your typical client look like? o How are you compensated? o Do you have account minimums? If so, what are they? o Do you work as a fiduciary? o Are you willing to provide references? o How much time will we spend together over the course of a year, and how will that happen? o Have you ever had any client complaints or regulatory issues? o What specific services do you offer? o What is your general investment philosophy and approach? o How frequently do you review portfolios and provide updates? o Why should I/we choose to work with you? o This question may not be appropriate, depending on the status of being a fiduciary in your territory. A better question may be to ask whether the individual always puts client interests first, and how that manifests in the way the advisor does business. International College of Financial Planning – Challenge Pathway Prep Book Page 136

In addition to having different risk appetite, behaviour, experiences, etc. clients also display certain personality traits that give insight into the type of investor that hey are or are likely to be. These are referred to as investor personalities, and they are an important factor in the creation and maintenance of a happy working relationship. In the context of Investing, Client Personality Types are of 4 types as summarized in the following graphic. Gathering Client Data Your goal during the data gathering meeting is to collect the information necessary to conduct an in- depth analysis of investment holdings and develop recommendations. This means you must: o Determine Client’s Investment Objectives o Determine Client’s Current Savings, Investments and Asset Allocation o Determine Client’s Risk Tolerance o Review Current Networth o Analyse Cash Flows available for investment and withdrawals from Investment o Determine Client’s Experiences, Attitude and Biases towards Investments o Identify Client’s Goals and Time Horizons International College of Financial Planning – Challenge Pathway Prep Book Page 137

Suitability: Using Risk Tolerance Information People are most often classified as having primary investment objectives that fall into one of the following categories: Conservative -Low risk tolerance -Primary objectives are to preserve value and receive regular income Moderately Aggressive -Willing to take some amount of risk for moderate returns -Objectives are more balanced—a combination of growth and income Aggressive -Willing and able to take on high levels of risk -Objective is growth (capital appreciation) alone—no income International College of Financial Planning – Challenge Pathway Prep Book Page 138

Understanding Life Stages It is easier for many clients to visualize their goals and discuss their objectives when their lives are broken down into life stages. Most people understand that they face specific financial challenges during the various stages of life. Each stage contains different priorities and focus, such as: Accumulation phase (to about age 35) -First job/career -Paying off debt -Begin saving and investing Consolidation phase (generally age 35 to 60) -Home purchase -Marriage -Children -Children’s education -Peak earning years -More investable income Retirement phase (generally age 60+) Page 139 -Income typically ends or is significantly reduced -Portfolios typically reallocated to a more conservative approach -Portfolio distributions -Wealth transfer -Long-term care issues International College of Financial Planning – Challenge Pathway Prep Book

Establishing Goals and Timelines  The investment time horizon is the period available until money is needed for a financial goal. A financial goal with a high degree of certainty and a short time period requires a focus on capital preservation, and therefore a selection of assets that remain stable in value (most likely interest-bearing instruments).  For example, an investor who plans to make a down payment on a house six months from now would want to keep that money in an asset with minimal risk, like a six-month certificate of deposit or money market account. Longer time horizons can allow for investments that, though they will fluctuate in value, offer increased appreciation potential.  For example, if the investment goal is accumulating $1 million for retirement 25 years from now, investments with higher long-term expected returns like common stock or long-term or high-yield bonds may be appropriate.  One of the biggest dangers to investing is overreacting to short-term market movements (i.e., buying high and selling low). Short-term volatility should be mostly irrelevant to people with a long-term investment time frame (typically considered to be greater than seven years), because the longer an investor can hold an investment, the more likely they can ride out market volatility and achieve positive results. SMART Goals International College of Financial Planning – Challenge Pathway Prep Book Page 140

Investment Policy Statement (IPS) An investment policy statement lays out the roadmap for a client’s situation, their goals/objectives, and the investment strategy or approach that is being used to achieve those goals. While the IPS describes the investment strategy/strategies to be used, it does not specify individual investment holdings. A well-written investment policy statement would allow another financial advisor to step in and quickly understand the client’s situation and goals, and be able to advise and guide the client. The IPS also helps financial advisors to keep their clients focused on their progress relative to their goals, rather than focusing on investment performance alone. Investment Objectives, Constraints and Suitability In many cases, an effective IPS can be written in just a few pages. Generally speaking, there is no set, approved format for an investment policy statement; however, a good IPS will contain most of the following items Executive summary that provides an overview, including: Page 141 -Current assets -Investment plan (i.e., how much will be invested, on what basis) -Timeframe -Return expectations over inflation and/or the risk-free rate International College of Financial Planning – Challenge Pathway Prep Book

-Risk profile (specifically, how much of a loss, or how much variability is acceptable) -Target asset allocation -Portfolio benchmarks Client description -Name -Type of account(s) being managed (individual, joint, foundation, etc.) -Address -Tax ID Investment objectives and client goals -What does the client want to achieve from his investments -What and when is desired Fiduciary responsibility -Where fiduciary responsibility is inappropriate (e.g., some territories do not use), substitute “client- first” responsibility Client responsibilities -Disclosing changes in financial situation, goals, assets, or risk tolerance Investment constraints -Timeframe -Liquidity requirements -Tax requirements -Legal and regulatory Investment philosophy Page 142 -Risk -Diversification -Trading and expenses International College of Financial Planning – Challenge Pathway Prep Book

-Core and noncore (i.e., satellite) holdings -Rebalancing Asset allocation strategy  Strategic  Tactical  Core/Satellite  Dynamic Security selection criteria  Geography & Asset Class Implementation, monitoring, and follow-up  Re-balancing agreement Review schedule  Timing: Quarterly, Semi-Annual, Annual International College of Financial Planning – Challenge Pathway Prep Book Page 143

Indian Financial Markets The Indian Economy In the modern world, the word ‘Economy’ is a widely used term in reference to the development or position or growth of a country. The word is so commonly used that in the financially literate circles, it is an immediately understood word but lacks a formal definition. That is because, the economic growth of a country is characterized by a diverse set of factors. Gross Domestic Product (GDP) is regarded by experts as a key indicator a nation’s economy. But production of goods and services and consumption is not the sole factor that measures the state and progress of the economy. There are other key macroeconomic indicators such as inflation, interest rates, employment, taxes, foreign exchange, exports, and monetary policies etc. to be considered. Market Infrastructure Institutions in India Indian Capital Markets are regulated and monitored by the Ministry of Finance, The Securities and Exchange Board of India and The Reserve Bank of India. The Ministry of Finance regulates through the Department of Economic Affairs - Capital Markets Division. The division is responsible for formulating the policies related to the orderly growth and development of the securities markets (i.e. share, debt and derivatives) as well as protecting the interest of the investors. In particular, it is responsible for – ● institutional reforms in the securities markets ● building regulatory and market institutions ● strengthening investor protection mechanism, and providing efficient legislative framework for securities markets The Division administers legislations and rules made under the Depositories Act, 1996, Securities Contracts (Regulation) Act, 1956 and Securities and Exchange Board of India Act, 1992. International College of Financial Planning – Challenge Pathway Prep Book Page 144

Reserve Bank of India – The Central Bank The Reserve Bank of India was established on April 1, 1935 in accordance with the provisions of the Reserve Bank of India Act, 1934. The Central Office of the Reserve Bank was initially established in Calcutta but was permanently moved to Mumbai in 1937. The Central Office is where the Governor sits and where policies are formulated. Though originally privately owned, since nationalisation in 1949, the Reserve Bank is fully owned by the Government of India. The Reserve Bank's affairs are governed by a central board of directors. The board is appointed by the Government of India for a period of four years. It contains one full-time Governor and not more than four Deputy Governors. The government also nominates non-official directors - ten from various fields, two government officials and four, each from the four regions of the country in Mumbai, Calcutta, Chennai and New Delhi. The Reserve Bank of India performs the supervisory function under the guidance of the Board for Financial Supervision (BFS). The Board was constituted in November 1994 as a committee of the Central Board of Directors of the Reserve Bank of India under the Reserve Bank of India (Board for Financial Supervision) Regulations, 1994. The primary objective of BFS is to undertake consolidated supervision of the financial sector comprising Scheduled Commercial and Co-operative Banks, All India Financial Institutions, Local Area Banks, Small Finance Banks, Payments Banks, Credit Information Companies, Non- Banking Finance Companies and Primary Dealers. The Board is constituted by co-opting four Directors from the Central Board as Members and is chaired by the Governor. The Deputy Governors of the Reserve Bank are ex-officio members. One Deputy Governor, traditionally, the Deputy Governor in charge of supervision, is nominated as the Vice-Chairman of the Board. Key Functions of the RBI Monetary Authority ● Formulates, implements and monitors the monetary policy ● Objective: maintaining price stability while keeping in mind the objective of growth Regulator and supervisor of the financial system ● Prescribes broad parameters of banking operations within which the country's banking and financial system functions International College of Financial Planning – Challenge Pathway Prep Book Page 145

● Objective: maintain public confidence in the system, protect depositors' interest and provide cost-effective banking services to the public Manager of Foreign Exchange ● Manages the Foreign Exchange Management Act, 1999 ● Objective: to facilitate external trade and payment and promote orderly development and maintenance of foreign exchange market in India Issuer of currency ● Issues and exchanges or destroys currency and coins not fit for circulation ● Objective: to give the public adequate quantity of supplies of currency notes and coins and in good quality Developmental role ● Performs a wide range of promotional functions to support national objectives Regulator and Supervisor of Payment and Settlement Systems ● Introduces and upgrades safe and efficient modes of payment systems in the country to meet the requirements of the public at large ● Objective: maintain public confidence in payment and settlement system Related Functions ● Banker to the Government: performs merchant banking function for the central and the state governments; also acts as their banker ● Banker to banks: maintains banking accounts of all scheduled banks Securities and Exchange Board of India The Securities and Exchange Board of India was established on April 12, 1992 in accordance with the provisions of the Securities and Exchange Board of India Act, 1992. The Preamble of the Securities and Exchange Board of India describes the basic functions of the Securities and Exchange Board of India as International College of Financial Planning – Challenge Pathway Prep Book Page 146