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Much of the Series 6 exam revolves around testing a candidate’s ability to make the right recommendations when it comes to investment products by analyzing their situation.

Following that, the customer will need to be told what kinds of risks that investments might have.

The key here is finding the balance between the investment characteristics the product provides as well as the overall objectives that the investor wants.

ANALYZING CUSTOMER ACCOUNTS AND ASSESSING RISK

To find the right products for a customer, a registered representative needs to select those that fit the customer’s investment needs.

We’ve covered most of how you would go about assessing each customer and finding out their unique needs in Module 2.

Now, we need to look at their investment portfolio, especially in light of the securities recommended and how they will perform.

Again, information is key here, none more so than regarding the investment experience of a customer.

As an example, a customer might want to be fairly aggressive as an investor.

They may like trading often and it’s then key to know if market prices are stable, moving up, or sliding, right?

Some investors are more into holding on to the securities that they buy and therefore are concerned with how the stock may be valued in 10, 15, or 20 years.

Here, understanding the growth earnings patterns will help find the investment opportunities for them.

Some investors may be conservative, particularly those that are approaching retirement.

They don’t want to take risks with their investments but will be interested in what kind of income suggested investments can provide a few years down the line.

It’s always important to compare similar products when measuring investment performance.

For example, a treasury bond yield and that of a growth mutual fund can never be compared.

That’s because, in a portfolio of investments, they just don’t have the same function.

So if you are looking at a growth fund’s performance, for example, measure it against other types of growth investments.

That’s key.

PORTFOLIO ANALYSIS THEORIES

There are a number of things to consider when it comes to applying portfolio analysis theories when dealing with each client.

Let’s look at them.

Asset allocation

When funds that the investor makes available for their portfolio are spread across different asset classes, that is known as asset allocation.

When it comes to the variability of returns in the performance of a portfolio, this can be a critical factor.

Those that punt asset allocation certainly feel that this mix of assets is a far better strategy than either market timing or individual stock selection.

When it comes to asset classes, there are three major types, each with subclasses:

  • Stock: Here foreign equity, value versus growth, and market capitalization are what subclasses are based on
  • Bonds: Here intermediate maturity, long term maturity, and type of issuer (Non-US, corporate, or treasury) are what subclasses are based on
  • Cash: Including short-term money market instruments, 13-week treasury bills, and other standard risk-free investments found in the financial industry

Asset allocation can also sometimes include tangible assets that reduce inflation risk.

These include:

  • REITs
  • Precious metals
  • Collectibles such as fine art

Also, alternative investment classes are often used by institutional investors which include venture capital, private equity, and hedge funds.

Now that we have a bit more background information, let’s look into strategic asset allocation.

This looks at a long-term investment portfolio but specifically at the proportion of all the types of investments that it is composed of.

In terms of portfolio management styles, it’s pretty passive because there are slow-moving and predictable conditions when it comes to portfolio rebalancing.

For example, the standard asset allocation model proposes that a registered representative should take the age of the specific customer that they are dealing with and take that away from 100.

That figure then can help determine the ratio in which the customer should be invested in stocks versus bonds/cash.

So if someone is 40, their investment allocation should then be 60% stocks and 40% bonds and cash.

And if they were 60, well then their investment allocation should be 40% and 60% bonds and cash.

The next strategy to look at is tactical asset allocation.

When we talk about this strategy, it’s all about portfolio adjustments that are more short-term.

Here, current market conditions are taken into consideration and the portfolio is then adjusted to income a mix of asset classes based on them.

It’s easy to see how this differs from the passive management approach of strategic asset allocation and yes, when it comes to the overall management style of the portfolio with this strategy, it’s far more active.

That’s because, in order to outperform market indexes, a manager has to be sure to pick the right kind of stock as well as time their stock sales or purchases effectively to make the strategy work.

So how would this strategy work?

Well, a portfolio manager or registered representative might ensure that a client’s portfolio is filled with stocks should the stock market be expected to perform for a period in the near future.

And should stocks be expected to drop in performance on the market, they could rather focus on bonds and cash instead of stocks.

Modern portfolio theory

MPT or modern portfolio theory uses a more scientific approach to portfolio management and was founded by Harry Markowitz.

The main thing here is the measurement of risk and then based on that, ensuring that the right kinds of investments are chosen for that portfolio.

This is also sometimes just known as portfolio theory.

By integrating both investments that are price-stable as well as those that are considered a little more volatile, MPT looks to minimize risk.

When Markowitz came up with this theory, he showed that diversified portfolios that have a greater chance of volatility ultimately fare worse than those built with lower volatility in mind.

The key here is the investments in the portfolio and the relationship between them all, something that MPT focuses on.

So by constructing portfolios of securities where there is no correlation in their returns, specific risks can be lowered through diversification.

While reducing risk, MPT also focuses on raising the returns expected at the same time.

Overall, the risk for an investor won’t be lowered by keeping securities that tend to move in the same direction as part of the portfolio.

That means, the portfolio should be filled with diverse securities that generally will move up and down but opposite to each other.

When using MPT, there are several analysis tools that registered representatives can use.

First, there is the Capital Asset Pricing Model (CAPM).

This looks at the asset’s systematic risk and based on that, tries to obtain an expected return.

CAPM has been around since the 1960s and was first developed by William Sharp.

Let’s break it down a bit further.

When looking at an investment, CAPM presumes that there are two distinct risks to every investment.

These are systematic (market) and unsystematic (business) risks.

Diversification won’t help in removing systematic risks.

The right kind of diversification, however, can diminish unsystematic risk.

So what does CAPM then calculate?

Well, it’s simple.

Based on the overall risk taken, it works out an investment’s return that it should achieve.

And we know that higher potential returns are potentially available when more risk is taken.

The required return that CAPM calculates is based on something called the beta coefficient which essentially is a risk multiplier.

Note that overall, unsystematic risk is lowered considerably when a portfolio is diversified.

In fact, the more diversification there is, at the end of the day, it’s practically zero.

In a fully diversified portfolio, that leaves systematic risk.

It can be offset by a required return on the investments.

The next tool is Beta Coefficient.

Sometimes, it will be referred to as beta, but it’s the same thing if you see it in this context.

So what does this measure?

Well, it’s a measurement of systematic risk, essentially.

Specifically, it looks at the overall market and measures a stock or portfolio volatility in relation to that.

A beta coefficient of 1.0 is given to the overall market which is usually based on the S&P 500.

A security is then said to be moving in line with the market if it too has a beta coefficient of 1.0.

When the beta coefficient is moving past the figure of 1.0, when compared to the overall market, it is seen to be more volatile.

The opposite is true should the beta coefficient drop below 1.0.

So when the S&P 500 rises by 10% for example:

  • 1.0 beta rated stock will rise by 10%
  • 1.5 beta rated stock will rise by 15%
  • 0.75. beta rated stock will rise by 7.5%

If the S&P 500 drops, then the opposite is true, of course.

Our next analysis tool is Alpha.

This looks at the degree at which the actual return of an asset or portfolio surpasses or fails to meet the expected return.

The ultimate aim here is to get a positive alpha, which means that the portfolio/asset has surpassed the expected return.

So let’s look at an example of how this works with regard to both negative and positive alphas.

When an investment’s beta is 1.5, it is considered to be 50% more volatile than the market (which has a beta of 1.0).

In this case, should the market move up by 10%, that investment is going to grow in the order of one and a half times the market, or 15%.

In the case that the market only grows by 11%, there is a less return on the investors’ money.

So because the return of 11% is under the 15% that was initially expected, we have a negative alpha.

Should the market have grown by 20%, then it’s over the expected 15% so that indicates a positive alpha.

The expected return is replaced with that required in the CAPM calculation of alpha.

So, while the volatility of a security can be seen thanks to its beta, alpha shows if the securities return, when compared to the risks taken, are doing better.

CAPM is one of the ways that analysis can make decisions as to when securities should be held, bought, or sold and they do this by looking at the required and expected return on a security.

Alpha plays a role here too as they will take the expected return for each share and subtract the required return from it

If the alpha is positive, the security should be bought.

Fundamental analysis

When making recommendations, registered representatives can employ fundamental analysis.

This looks at both the industry a company operates in, as well as the overall condition of the economy, and studies the business prospects of that company in that regard.

Key aspects of the company will be studied by analysts when this is carried out including taking a look at company management as well as the financial statements of the business.

Let’s look at this in more depth starting with the types of industries and business cycles.

Often, the way an industry is affected by the normal business cycle can help us to categorize them.

Before we get onto this, just a reminder that in a business cycle, there are four stages: these are expansion, peak, contraction, and trough.

Industries can be categorized as cyclical, countercyclical, defensive, growth, or special.

Let’s look at a few examples.

  • Cyclical industries

Inflation trends and business cycles can easily affect cyclical industries.

These types of industries tend to produce durable or capital goods, automobiles and light trucks, heavy equipment (including cranes, planes, tractors), and steel (or those that make products from it).

Recessions can have an impact on cyclical industries because the demand for the goods they produce drops.

  • Countercyclical industries

With these industries, if the economy is doing well, they will tend to perform worse while if the economy is struggling, the opposite is true.

An excellent example of a countercyclical industry is gold and gold mining stocks.

  • Defensive industries

When it comes to normal business cycles, it’s defensive industries that are affected the least and that’s because demands for the goods produced by these industries remain relatively steady at all times.

This industry covers nondurable consumer goods including utilities, tobacco, pharmaceuticals, and food.

So stocks that are bought from companies that are positioned in defensive industries will decline at a slower rate, even if the economy is contracting due to a recession or bear markets, for example.

Should the economy be growing, when compared to other stocks that might thrive during this period, those bought from companies in defensive industries will grow far slower.

So it’s a case of while there is less risk associated with these types of stocks, the investment returns are lower too.

  • Growth industries

In reality, all industries move through four distinct stages starting with their introduction, moving on to their growth, then their maturity, and finally their decline.

The growth phase occurs with certain conditions in place.

These conditions will see the industry growing at a far faster rate than the economy currently is.

This could be a result of changing consumer spending, the launch of new products, or because of technological changes, for example.

Examples of growth industries are those associated with various computer technologies as well as bioengineering, but there are many others.

The thing with growth industries is that often, their stocks will not pay many dividends to investors, if at all.

That’s because, most of the time, any money that’s made is put straight back into the business to fund expansion.

TOOLS OF FUNDAMENTAL ANALYSIS

For the most part, this approach means using a top-down method with regard to investing.

This includes an overview of the current economy.

From that point, it’s about identifying with that current economy, the types of industries that can perform in those conditions.

From there, it’s all about narrowing the search and finding companies in that specific industry to invest in.

Obviously, finding the best company means carrying out a comprehensive analysis.

This will include looking at factors such as the:

  • Quality of the management group
  • Market share
  • New products

It also includes looking at the financials of the company that are available, in other words, their overall balance sheet health as well as other financial statements.

By using this information, an analysis of the operating efficiency, overall financial strength, and the profitability of the company.

This information is easy to find as well as any company that issues shares will provide both quarterly and yearly financial reports to the SEC.

More often than not, this will also have a balance sheet as well as the income statement of the company in it.

These are invaluable in comparing various potential companies that could be invested in against each other.

Let’s talk a little more about those critical financial documents that can help provide the relevant analysis.

Balance sheet 

This is a pretty important document for one main reason and that is because it shows the overall position of a company from a financial perspective at a particular time.

Basically, it shows what a company owns, or its assets against what it owes, or its liabilities.

If you take one away from the other, you can quickly determine the overall net worth of a company.

When we talk about the balance sheet equation that shows this we say owners’ equity = assets – liabilities.

A balance sheet shows the financial position at a specific moment in time as we’ve already mentioned.

That means it’s not going to help an analyst tell if the company is on the way up or down when it comes to the overall condition of their business.

Let’s look into assets a little more.

These will be shown on the balance sheet in a particular order.

This order is related to how easy and quickly the asset can be turned into a source of cash.

This is known as the order of liquidity.

Those listed first can become cash the easiest and as you go down the list, the remaining assets are less-liquid the lower you go.

On a balance sheet, three types of assets are identified.

  • Current assets

This covers a period of 12 months and will include all the cash on hand a company has as well as any liquid asset that can be converted into cash during that period.

This will include:

– All cash, safe short-term investments that can be easily sold, and marketable securities

– Accounts receivable for delivered goods or services rendered (depending on the business).

– Any prepaid items a company has yet to benefit from but has already paid for which could include supplies, rent, advertising, or insurance.

  • Fixed assets

This covers company equipment and property, for example.

It cannot be readily converted into cash but should the need arise, it can be sold down the line.

Note that with fixed assets, their overall value can drop.

Think of a fleet of vehicles for example.

They are not in the same condition five years after they were driven off the showroom floor, right?

That’s where depreciation comes in and to compensate for this loss in value, it can be taken off taxable income in installments each year.

  • Other assets

Here, a company might list its intangible assets.

Take Coca-Cola, for example

The name alone is an intangible asset because the whole world knows what Coca-Cola is, right?

Other intangible assets include contract rights, company trademarks (think the Starbuck logo), and formulas (Colonel Sanders’ secret recipe of herbs and spices for KFC, for example).

Those are all examples of intangible assets and they are linked to the reputation of a company as well as their clients and the relationship they hold with them.

Now we move on to liabilities.

These can be categorized as current or long-term and are financial obligations that a company has.

With long-term liabilities, the payment thereof won’t be due imminently.

An example of a corporation’s long-term liabilities is the bonds they have issued, for example.

Current liabilities are going to be payable soon, usually within the period of a year.

The next part of the balance sheet to consider is net worth.

This is all the retained earnings the corporation has,

Any invested capital too must be added to the net worth of the corporation as well.

In essence, this figure shows just what the corporation is worth.

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