Ethics in Financial Planning

Conflict of Interest

• A conflict of interest exists when a financial planner (FP) has the opportunity to prioritize their own interests over those of the client.
• An example is advising a client to purchase a particular product solely because the FP earns commission, rather than providing objective recommendations.
• To avoid conflicts of interest, FPs should disclose any commissions and ensure that recommendations are based on the client's personal circumstances and objectives, regardless of any personal benefits.

Statement of Advice (SoA)

• A Statement of Advice (SoA) is a document that details the advice provided and its context.
• It is required when personal financial advice is given, before any action is taken to implement the advice.
• The SoA must include:
  • Product details, explaining the recommended product's advantages over alternatives.
  • Information about the advisor, including their name, qualifications, contact details, and the name of the authorized principal they represent.
  • Details about remuneration and benefits received by anyone involved (fees, charges, and distribution methods).
  • Disclosure of any associations that could potentially influence the advice provided.
  • A warning if the advice is based on inaccurate or insufficient information.
  • Reasons for replacing one product with another.
• Advice can be provided without a SoA in specific circumstances:
  • When investments, basic deposit products, or super amounts are less than $15,000.
  • When the advice solely consists of an offer to sell a product, and the client makes it clear that they do not intend to buy, no sale results, and the advice is given over the phone for traded products, subject to client approval and the advisor providing an FSG.
• When the SoA recommends replacing one product with another, additional details must be provided:
  • Benefits of switching to the alternative product.
  • Potential losses resulting from disposing of the original product.
  • Charges associated with disposing of the original product.
  • Charges for switching to the alternative product.
  • Any other significant consequences of the action.

Product Disclosure Statement (PDS)

• A PDS is a document that provides information about a financial product, including risks, tax implications, fees, expenses, charges, and any other relevant details that would influence the client's decision.
• It is required before a client becomes legally obligated to acquire the product or invest in it.
• The PDS can be provided electronically, such as through email.

Financial Services Guide (FSG)

• An FSG discloses the services offered to a client.
• It is required to be presented at the beginning of negotiations.
• An FSG must include:
  • The title "Adviser Financial Services Guide" or "FSG".
  • Name and contact details of the advisor.
  • Information about the authorized principals, including their names and contact details.
  • Disclosure of who the advisor represents when providing services.
  • Information about any business relationships or associations between the principal and issuers of products.
  • Details of internal and external complaints resolution mechanisms.
  • A statement affirming the FSG's authorization by the principals.

Asset Allocation

• Different investments exhibit varying performance levels according to their associated risks, with equities typically offering higher potential returns but also carrying greater risk compared to real property and bonds.
• Expected return is directly related to risk.
• In Australia, the long-term returns on equities have averaged between 10% and 11.5% p.a. However, equities experience substantial short-term volatility.
• Historically, the equity (risk) premium has hovered around 4-6%.
• Inflation-adjusted ("real") rates of return have remained relatively consistent over time.

Investment Portfolio Construction

• Investment portfolio construction involves two key stages:
  • Asset allocation (macro decision): Determines the percentage of funds allocated to different asset classes based on risk tolerance, financial goals, and investment horizon.
  • Security Selection (micro decision): Involves choosing and investing in specific securities within each asset class. This decision depends on the fund's risk profile, regulatory constraints, ethical guidelines, sector preferences, and economic forecasts.

Active vs Passive Management

• Active management involves frequent buying and selling of securities to capitalize on short-term price fluctuations. Its objective is to "buy low, sell high" and maximize gains.
• Passive management embraces a buy-and-hold strategy, based on the belief that markets are generally efficient and achieving consistent outperformance through active trading is difficult. Its objective is to achieve long-term growth by holding investments without frequent trading.

Bonds

• A bond is a contract between the issuer and the investor, outlining the issuer's obligation to make specific cash payments to the investor on predetermined dates.
• This obligation includes the principal plus interest (compensation for using the funds).
• Types of bonds include coupon paying bonds, zero-coupon bonds, convertible bonds, callable bonds, annuity bonds, asset-backed bonds, indexed bonds, and junk (non-investment grade) bonds.
• Bonds offer a lower risk compared to equities but present lower potential returns.
• Key risks associated with bonds: interest rate risk, reinvestment risk, inflation risk, credit/default risk, liquidity risk, and rating downgrade risk.

Investment-Grade Bonds

• Investment-grade bonds are considered safer investments with lower default risk, making them attractive to a wide range of investors.
• They offer issuers lower borrowing costs and improve access to capital.
• Investors benefit from better liquidity, stability, and potentially lower volatility in their investment portfolios.
• Being classified as investment-grade is vital for maintaining investor confidence and accessing broader capital markets on favorable terms.

Coupon-Paying Bonds

• Coupon-paying bonds offer regular fixed payments of interest (C) plus repayment of the principal at maturity (F).
• Interest payments (C) are typically made biannually and determined by the bond's face value and interest rates.
• Investors can withdraw their funds at any time, making them suitable for those requiring quick access to their money.

ETF vs CMT

• Bond ETFs (Exchange Traded Funds) have gained popularity due to their greater flexibility, lower costs, ability to trade throughout the day, diversified exposure to a broad range of bonds, and lower management fees.

Debt

• Debt imposes a contractual obligation on a firm to make regular payments of interest and principal to lenders.

Equity

• Equity, the counterpart to debt, represents a residual claim on the cash flows generated by a firm's assets.
• Equity holders have a lower claim on the firm's cash flows compared to debt holders.
• Dividends are paid after interest payments.
• Capital is returned after borrowings are repaid.
• An equity risk premium exists, reflecting the higher risk associated with equity investments.
• Equity can be generated from internal sources (retained earnings) or external sources (new issues).

Long-Term vs. Short-Term Returns on Equities

• Long-term equity investments have historically demonstrated stable and higher returns compared to other asset classes, such as bonds or cash.
• However, in the short term, equity investments carry significant risk due to market volatility.
• Stock prices can fluctuate drastically, potentially resulting in substantial losses.

How Risky Are Shares?

• Investing in shares involves practical considerations and risks:
  • How and Where to Buy Shares: Shares of publicly listed companies are traded on stock exchanges, such as the Australian Stock Exchange (ASX). Investors need to contact a broker and establish a trading account.
  • Which Shares to Buy: Choosing which shares to buy requires thorough research into companies, understanding market trends, and considering diversification strategies to mitigate risk.

Property Investments

• Property investments involve taking out a mortgage or loan to fund the purchase.
• Lenders typically require:
  • Evidence of sufficient salary/wages to service the loan (including interest and principal payments) and proof that employment is ongoing.
  • A stress test using a higher interest rate than the current one to assess the borrower's capability to handle interest rate rises.
  • Evidence of a savings discipline history (statements).
  • Proof of having the required deposit for the loan.
  • A credit check to confirm the absence of default loans.
  • A valuation or other evidence that the purchase price reflects the property's value.
• A deposit is typically required, typically at least 20% of the purchase price for most mortgage loans.
• Mortgage insurance may be required, particularly for loans with a Loan to Valuation Ratio (LVR) exceeding 80%, to protect the lender against loan default.
• The borrower pays the mortgage insurance premium, which increases with higher LVRs.
• Typically, lenders require property insurance and potentially contents insurance on the mortgaged property.

Stamp Duty

• State governments levy land duty, also known as stamp duty, which is roughly proportional to the purchase price. Higher-priced properties incur higher stamp duty.
• Duty can be reduced by purchasing land and then building on it, as only the land incurs duty.
• Specific duty reductions apply to first-home buyers and properties purchased "off the plan" (before construction is complete).

Alternative Home Loans

• Several alternative home loan options are available, including:
  • Fixed rate mortgages: Offer a fixed interest rate for a specified period, providing interest rate certainty.
  • Interest only mortgages: Only require interest payments on the loan, leaving the principal untouched.
  • Mortgage offset accounts: Everyday bank accounts linked to a home loan, where savings and salary deposits offset the outstanding loan amount, reducing interest charges and generating potential tax savings.
  • Low-start loans: Offer lower initial interest rates, which gradually increase over time.
  • Capital indexed loans: Interest rates increase as inflation rises, potentially offering lower initial interest rates.
  • Cocktail loans: Combine fixed and variable interest rates, offering flexibility and potential cost savings.

Rent vs. Buy

• Purchasing a property means paying a mortgage and eventually owning the property.
• Renting allows the difference between rent payments and a potential mortgage payment to be invested in an investment portfolio or superannuation.
• The required deposit size for a property purchase significantly impacts the outcome.
• The decision to buy often requires a savings discipline, whereas renting does not.