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D. Misconduct
#analyst-notes #code-of-ethics-and-standards-of-professional-conduct

I. PROFESSIONALISM

D. Misconduct.

You must not engage in any professional conduct involving dishonesty, fraud, or deceit, or commit any act that reflects adversely on your professional reputation, integrity, or competence.

Do NOT compromise the integrity of the CFA designation, or the integrity of the CFA examinations.

Standard I (A) states the obligation to comply with all applicable laws and regulations. This standard addresses personal behavior that will reflect poorly on the profession as a whole. Any act that involves lying, cheating, or other dishonest conduct, if the offence reflects adversely on your professional (not personal) activities, would violate the standard.

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D. Misconduct
#analyst-notes #code-of-ethics-and-standards-of-professional-conduct
Procedures for compliance

Members and candidates should encourage their employers to:

  • Adopt a Code of Ethics. Make clear that any behavior that reflects poorly on the individual, the institution, or the industry will not be tolerated.
  • Give employees a list of potential violations and their disciplinary sanctions, including dismissal from the firm.
  • Do background checks on potential employees to ensure that they are of good character and do not have past infractions of the law.

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D. Misconduct
#analyst-notes #code-of-ethics-and-standards-of-professional-conduct
Example 1

An investment advisor executes excessive trading volume to generate fees. He tells clients that the high level of trading in their discretionary accounts is needed to maintain proper diversification. If this statement is misrepresentative, the advisor is clearly engaging in professional misconduct.

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D. Misconduct
#analyst-notes #code-of-ethics-and-standards-of-professional-conduct
Example 2

A portfolio manager has three martinis at lunch and returns to the office to resume his regular duties. If the manager's judgment is impaired and he is engaging in investment decision-making activities, he is in violation of this standard.

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A. MATERIAL NON PUBLIC INFORMATION
#analyst-notes #code-of-ethics-and-standards-of-professional-conduct #integrity-of-capital #markets
If you possess material nonpublic information that could affect the value of an investment you must not act or cause others to act on that information.

Information is material if its disclosure may affect the price of a security, or if reasonable investors would want to know the information before investing. Topics which should be considered material in an insider trading context include:

  • A forthcoming dividend declaration or mission.
  • Corporate reorganizations or takeovers.
  • The acquisition or loss of a major contract.
  • A major purchase or sale of company assets.
  • An event of default.
  • Knowledge of forthcoming press coverage of a company's affairs, whether positive or negative.
  • Substantial increases or decreases in earnings projections.

The source or reliability of the information also determines materiality. The less reliable, the less material.

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A. MATERIAL NON PUBLIC INFORMATION
#analyst-notes #code-of-ethics-and-standards-of-professional-conduct #integrity-of-capital-markets
Information is nonpublic if it has not been published, or if investors have not had an opportunity to react to the information. Note that disclosing the information to a selected group of analysts does not make it public. For example, a disclosure made to a room full of analysts does not make the disclosed information "public."

Note that this standard prohibits use of material nonpublic information, not:

  • Nonmaterial public information.
  • Nonmaterial nonpublic information.
  • Material public information.

You are prohibited from seeking or using any inside information in making investment decisions if:

  • Such trading would breach a duty.
  • The information is misappropriated.
  • The information relates to a tender offer.
  • Members receive material information in confidence.

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A. MATERIAL NON PUBLIC INFORMATION
#analyst-notes #code-of-ethics-and-standards-of-professional-conduct #integrity-of-capital-markets
Mosaic Theory

Insider trading dont happen when a perceptive analyst reaches a conclusion through an analysis of public information and items of NONMATERIAL nonpublic information (i.e., a "mosaic" of information).

Under mosaic theory, financial analysts are free to act without risking liability. That is, a financial analyst may use nonpublic information as the basis for investment recommendations and decisions even if that conclusion would have been material inside information had it been communicated directly to the analyst by a company.

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A. MATERIAL NON PUBLIC INFORMATION
#analyst-notes #code-of-ethics-and-standards-of-professional-conduct #integrity-of-capital-markets
Procedures for compliance

If members receive inside information, they shall make efforts to achieve public dissemination of material nonpublic information disclosed in breach of duty. Including encouraging the company to make the information public.

Firms should adopt written compliance procedures. The most common approach is an information barrier known as a "fire wall", Which prevents communication of material nonpublic information and other sensitive information between departments.

The minimum elements of such a precaution include the following:

  • Control (preferably by compliance) of interdepartmental communications.
  • Review of employee trading with a combination of "watch," "restricted," and "rumor" lists.
  • Procedures to limit flow of information between departments and of the enforcement of them.
  • Careful review or restriction of proprietary trading while the firm is in possession of material nonpublic information.

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A. MATERIAL NON PUBLIC INFORMATION
#analyst-notes #code-of-ethics-and-standards-of-professional-conduct #integrity-of-capital-markets
Additional Compliance procedures, used typically in conjunction with an information barrier, include:

  • Restricting or prohibiting personal and proprietary employee trading.
  • Monitoring of firm and personal employee trading. Can be easily detected if employees and if firm requires to make periodic reports of their transactions on their own behalf or of their families.
  • Placing securities on a restricted list if firm has material nonpublic information (unless this tend to reveal that the firm is engaged in a nonpublic engagement to the security).
  • Using a stock watch list known only to a limited number of people when the firm has or may have material nonpublic information, to monitor transactions in specified securities.
  • Limiting the material nonpublic information to persons who have a need to know it.
  • ​Designating a supervisor who will have the authority and responsibility to decide whether information is public or lacking in materiality enough that it may be used for investment decisions.
  • Firms should circulate written policies and guidelines employees and have seminars and courses about it

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A. MATERIAL NON PUBLIC INFORMATION
#analyst-notes #code-of-ethics-and-standards-of-professional-conduct #integrity-of-capital-markets
Example 1

An insider tells you that his firm will announce a significant drop in EPS for the upcoming year. The announcement will be released in three days. You can't trade. You can't recommend that your investors sell their positions. You can (and should) encourage the firm to disclose the information immediately.

Example 2

You are at an analysts' briefing for Horton Industries attended by 20 analysts. During the presentation, Horton's president indicates that the firm is considering closing its Alberta operations because of difficulty controlling costs at that location. He asks the audience not to act on this information yet because a final decision will not be made for at least another week. The analysts' briefing does NOT qualify as a public disclosure. You can not inform your clients of the new information and trade on their behalf.

Example 3

Barnes, the president of XYZ decides to accept a proposed tender offer. He tells this decision to his sister, who tells her daughter, who tells her husband, who tells his broker, who buys stocks for himself. The broker is prohibited from trading the XYZ stock because the information involves tender offer. However, the broker has no reason to believe a duty was breached in the transmission of the information.

Example 4

A passenger in an elevator overhears a conversation between two executives of a publicly traded company. The passenger trades the stock based on that information. The passenger does not violate the standard because the executives do not breach any duty and the information is not misappropriated.

Example 5

Walsh overhears that someone sneaked into the CEO's office and discovered information about a pending tender offer. Walsh subsequently trades the stock. Walsh violates the standard because the information is misappropriated and it concerns tender offer.

Example 6

An analyst fails to protect privacy when discussing nonpublic information in a conference call. Another employee overhears the information, and subsequently trades for his clients' accounts. The analyst violates the standard for lack of adequate procedures. The firm should have established information barriers, also called fire walls, between departments.

Example 7

A magazine has a weekly investment column. A magazine employee trades on information in the column before it is published. The employee violates the standard because the information is misappropriated.

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Subject 2. The Six Components of the Code of Ethics
#analyst-notes #code-of-ethics-and-standards-of-professional-conduct
Members and Candidates must:

  • Act with integrity, competence, diligence, respect, and in an ethical manner with the public, clients, prospective clients, employers, employees, colleagues in the investment profession, and other participants in the global capital markets.

  • Place the integrity of the investment profession and the interests of clients above their own.

  • Use reasonable care and exercise independent professional judgment when conducting investment analysis, making investment recommendations, taking investment actions, and engaging in other professional activities.

  • Practice and encourage others to practice in a professional and ethical manner that will reflect credit on themselves and the profession.

  • Promote the integrity of, and uphold the rules governing, capital markets.

  • Maintain and improve their professional competence and strive to maintain and improve the competence of other investment professionals.

The Code of Ethics establishes the framework for ethical decision-making in the investment profession.

It applies to CFA Institute's members, CFA charterholders and CFA candidates.

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B. Market Manipulation.
#analyst-notes #code-of-ethics-and-standards-of-professional-conduct #integrity-of-capital-markets

You must not engage in practices that distort prices or artificially inflate trading volume with the intent to mislead markets.

Market manipulation is an attempt to interfere with the free and fair operation of the market. It includes practices with the intent to deceive people or entities that rely on information in the market.

Market manipulation examples include:

  • Price manipulation. Placing orders into the trading system in order to change the price of a stock. The motives for attempting to do this vary: to increase the value of a position for finance or accounting purposes, to be able to issue new shares at a higher price or to cause such a price rise that other investors are attracted to the stock, creating demand that the manipulator can sell into (called "pump and dump").

  • Marking the close or ramping. Making a trade near the close of the day's trading, trying to affect published prices, particularly the reported closing price. This is done to avoid margin calls (when the trader's position is not self-financed) to support a flagging price or to affect the valuation of a portfolio (called "window dressing"). A common indicator is trading in small parcels of the security just before the market closes.

  • Wash trades and pre-arranged trading. A wash trade is a trade in which there is no change in the beneficial ownership of the securities - the buyer is, in reality, also the seller. A pre-arranged trade involves two parties trading on the basis that the transaction will be reversed later, or with an arrangement that removes the risk of ownership from the buyer. "Pooling or churning" can involve wash sales or pre-arranged trades executed in order to give an impression of active trading, and therefore investor interest, in the stock.

  • False or misleading information. Companies can be tempted to re-release information or present information in an over-optimistic manner, in order to generate interest in the company's securities or help a flagging market. In some cases this includes unrealistic, unsubstantiated, or incorrect data, projections or evaluations. When the perpetrators use the demand generated by the false information they have spread to sell their own shares, the operation is known as "hype and dump."

  • Capping and pegging. This involves activity on both the stock market and the derivatives market. A trader writes an option, which obliges the trader to sell to (in the case of a call option) or buy from (in the case of a put option) the option holder a specified number of shares at a specified price. The trader then trades in the shares covered by the option in order to affect the share price in a direction that will make the option unprofitable to exercise.

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B. Market Manipulation.
#analyst-notes #code-of-ethics-and-standards-of-professional-conduct #integrity-of-capital-markets
  • The intent of the action is critical to determining whether it is a violation of this standard.
  • The standard does not prohibit legitimate trading strategies that exploit a difference in market power, information, or other market inefficiencies. It also does not prohibit transactions done for tax purposes (e.g., selling and immediately buying back a particular stock).

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A. Loyalty, Prudence, and Care.
#analyst-notes #code-of-ethics-and-standards-of-professional-conduct #iii-duties-to-clients

You have a duty of loyalty to clients and must act with reasonable care and prudent judgment, act for their benefit and place clients' interests before your employer's or your own.

This standard relates principally to members who have discretionary authority over the management of client's assets.

Fiduciary duty is the obligations of loyalty and care in regard to the responsibility of managing someone else's assets. A fiduciary duty is a position of trust.

  • A fiduciary is someone with the duty of acting for the benefit of another party.
  • Loyalty is owed to clients and prospects.
  • Clients' interests come before yours.
  • A heightened level of fiduciary duty arises if the fiduciary has "custody" or effective control of the client's assets.
  • Governing documents (e.g., trust documents and investment management agreements) are primary determinants of a fiduciary's powers and duties.

Fiduciary standards apply to a large number of persons in varying capacities, but exact duties may differ depending on the relationship with the client or the type of account under which the assets are managed.

The first step in fulfilling a fiduciary duty is to determine what the responsibility is and the identity of the "client" to whom the fiduciary duty is owed.

  • When managing personal assets of an individual, the investment manager owes loyalty to that individual (i.e., the client).
  • When managing the portfolios of a pension plan or trust, the investment manager owes loyalty to beneficiaries of the plan or trust (i.e., the "client"), not the person who hires the manager.

A fiduciary must make investment decisions in the context of the portfolio as a whole rather than by individual investments within the portfolio. The fiduciary should thoroughly consider the risk of loss, potential gains, diversification, liquidity and returns.

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A. Loyalty, Prudence, and Care.
#analyst-notes #code-of-ethics-and-standards-of-professional-conduct #iii-duties-to-clients
Managers often have discretion over the selection of brokers. The broker may provide research services that provide a benefit to the manager. The manager has thus used "soft dollars" to purchase an asset to his clients. Since the manager would expect to purchase research services anyway, the soft dollar arrangement is not necessarily inappropriate. The manager must seek the best price and execution, and DISCLOSE any soft dollar arrangements.

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A. Loyalty, Prudence, and Care.
#analyst-notes #code-of-ethics-and-standards-of-professional-conduct #iii-duties-to-clients
  • Follow all the applicable laws and rules.
  • Establish the investment objectives of the client, taking into account:

    • The client's needs and circumstances.
    • The investment's basic characteristics.

  • Diversification. All portfolios should be diversified, unless the plan guidelines state otherwise.
  • Deal fairly with all clients.
  • Conflicts of interest. All conflicts must be disclosed.
  • Disclose compensation agreements.
  • Proxy solicitations. Proxies must be voted in the best interest of the beneficiaries.
  • Confidentiality. Members must maintain the confidentiality of their dealings at all times.
  • Best execution. The best execution that is reasonably available should be provided to all clients.
  • Loyalty - members must always act in the best interest of their clients.

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A. Loyalty, Prudence, and Care.
#analyst-notes #code-of-ethics-and-standards-of-professional-conduct #iii-duties-to-clients
Example 1

A client anxiously tells you that he needs to liquidate a bond portfolio immediately because he needs funds to pay for an operation for a relative. The bonds are highly liquid, but you and a colleague purchase the securities for about 75% of their market value. This is a clear violation of your fiduciary duty to the client. You have violated your position of trust. Furthermore, you have engaged in a deceitful action, which dishonors the CFA designation.

Example 2

A portfolio manager benefits a pension plan's sponsor rather than its beneficiaries by acquiring the sponsoring company's stock with the pension fund, to support its stock price, and voting proxies in support of the management, which is not in the best interest of the beneficiaries. He violates the standard because he should have made investment decisions solely in the interest of the beneficiaries of the pension plan, regardless of the sponsor's benefits.

Example 3

A portfolio manager directs trades to a brokerage firm. In return, he gets favorable treatment on his personal transactions. He violates the standard because he breaches his fiduciary duty to clients. He should have hired a brokerage firm that offers the best execution for the client.

Example 4

A portfolio manager receives research from a brokerage firm that does not directly benefit the accounts being traded. He does not violate the standard as long as he gets the best execution for his clients and discloses the soft dollar arrangement to them.

Example 5

An investment firm uses a large brokerage house, ABC. ABC's research is average, but provides asset allocation studies to make up for the large commission charged. The firm is also very friendly with ABC senior management. The standard has been violated, since soft dollars have been paid, but not for research activities.

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B. Fair Dealing.
#analyst-notes #code-of-ethics-and-standards-of-professional-conduct #iii-duties-to-clients
You must deal FAIRLY and OBJECTIVELY with all clients when providing investment analysis, making investment recommendations, or engaging in other professional activities.

"Fairly" implies that you must not discriminate against or favor any clients. Fairness shall be maintained in quality and timing of services, and allocation of investment opportunities. The term "fairly," rather than "equally,", is used because it would be physically impossible to reach all customers at the same exact instant, and not all recommendations or investment actions are suitable for all clients.

Members and candidates are NOT required to give the same level of services to all clients. For example, you can give more information and research to discretionary clients than to transaction-only clients.

Members and candidates are required to adhere to the standard in:

  • Dissemination of recommendations: Establish procedures for simultaneous dissemination of recommendations; all clients must be informed at approximately the same time.

    An investment recommendation is any opinions on buying, selling, or holding a security or other investment. Good business practice dictates that initial recommendations be made available to all customers who indicate interest. Although a member need not communicate a recommendation to all customers, the selection process by which customers receive information should be based on suitability and known interest, not on any preferred or favored status. A common practice to ensure fair dealing is to communicate recommendations within the firm and to customers simultaneously.

    A material change in a firm's recommendation is one that could be expected to affect a client's judgment. A change in the recommendation from buy to sell is a material change; this standard needs to be abided by in disseminating the change.

  • Investment actions: Develop trade allocation procedures to ensure fairness to clients (both in priority of execution and allocation of price obtained on block trades), timeliness of execution, accuracy of trade records, and client positions.

    Clients in discretionary accounts should be treated the same as those who are not in discretionary accounts. Note that investment action can affect the market value of a security.

    If an issue is oversubscribed, members should forgo any sales to themselves or their immediate families. Members must disclose to clients or prospects the allocation procedures, and how they can affect the clients or prospects. Members shall not withhold "hot issue" securities for their own benefits or use such securities as rewards or incentives for others. Members shall not trade ahead of the dissemination of research reports or recommendations to clients.

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B. Fair Dealing.
#analyst-notes #code-of-ethics-and-standards-of-professional-conduct #iii-duties-to-clients

Procedures for compliance

  • Limit the number of people involved.
  • Shorten the time frame between decision and dissemination.
  • Publish personnel guidelines for pre-disseminations.
  • Disseminate information simultaneously to all parties.
  • Maintain a list of clients and their holdings.
  • Develop and disclose written trade allocation procedures.
  • Establish systematic account review.
  • Disclose levels of service.

Members and their firms are required to take the following steps to ensure that adequate trade allocation practices are followed:

  • Obtain advance indications of client interest for new issues.
  • Allocate new issues by client rather than by portfolio manager.
  • Adopt a pro rata or similar objective method or formula for allocating trades.
  • Treat clients fairly in terms of both trade execution order and price.
  • Execute orders in an efficient and timely manner.
  • Keep accurate records of trades and client accounts.
  • Periodically review all accounts to ensure that all clients are being treated fairly.

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B. Fair Dealing.
#analyst-notes #code-of-ethics-and-standards-of-professional-conduct #iii-duties-to-clients
Example 1

After attending an analysts' briefing, you decide to re-evaluate your research report on Horton Industries. You conclude that the company is no longer a "buy" but is instead a "strong buy." The report is scheduled for release to your clients next week but you call several large clients to inform them of this change. You have not treated all clients fairly.

Example 2

An analyst tells a client that he will soon issue a recommendation. He violates the standard because he should send the information to all clients before discussing it with any specific client(s).

Example 3

Just 30 minutes before the close of the market, Huntington Biomedical releases a report indicating that EPS for the upcoming quarter will be materially lower than previously expected and that sales growth for the firm will also be below expectations for the next four quarters. You only have three clients with significant positions in Huntington. You contact each of those clients and two of them direct you to liquidate their holdings in the firm immediately. The third client elects to hold her position. Even if you have other clients with small positions in this firm, you have treated all clients fairly. You have shown preference to clients with greater concern about the news release.

Example 4

An analyst's employer low-balls earning projection for company XYZ. The analyst is confident that the earnings should be higher, but goes along with the firm when issuing his own recommendation. Then he passes his real estimate to his large clients. He violates the standard by not sharing his recommendation with all clients and not treating all clients fairly.

Example 5

An analyst, Jessica, follows the mining industry. She finds that a small mining house has just signed some significant deals with companies she researches or follows. She then investigates it further and decides to write a report recommending the company purchase. While the report is still in the draft stage, Jessica organizes a breakfast for her biggest and best clients and discusses this small company with them. At the breakfast she tells her best clients that she has a buy recommendation on the report (which will be released in three days). Jessica has violated the standard because she disseminated investment recommendation information that was contained in a research report to her best clients before the report had been disseminated to all her clients fairly.

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C. Suitability.
#analyst-notes #code-of-ethics-and-standards-of-professional-conduct #iii-duties-to-clients

1. When in an advisory relationship with a client, you must:

a. Make a reasonable inquiry into a client investment experience, risk and return objectives, and financial constraints prior to making any recommendation or taking investment action and update this information regularly.

b. Determine that an investment is suitable to the client's financial situation and consistent with the client's written objectives prior to making an recommendation or taking investment action.

c. Judge the suitability of investments in the context of the client's total portfolio.

2. When you are responsible for managing a portfolio to a specific mandate, strategy, or style, they must only make investment recommendations or take investment actions that are consistent with the stated objectives and constraints of the portfolio.

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C. Suitability.
#analyst-notes #code-of-ethics-and-standards-of-professional-conduct #iii-duties-to-clients
you must always consider the suitability of the client's investment action and match this to the needs of the particular client in order to determine the suitability of the investment.

If a new client is obtained or an existing client's previous investment matures, you need not immediately obtain client information if he or she first re-invests these funds in cash equivalents.

You will then obtain the client's investment preferences. You will need to determine from the client the level of risk that the client is prepared to accept (in other words, the client's risk tolerance level). This needs to be ascertained before any investment action is taken.


You are required to:

  • Know the type and nature of your clients'.
  • Know the return objectives and risk tolerance of your clients.
  • Know the liquidity needs, expected cash flows, investable funds, time horizon, tax considerations, regulatory and legal circumstances, and other constraints of your clients.

You are NOT required to change an existing client portfolio as soon as it comes under your discretion; it is best to take a bit of time, plan and implement actions in an organized way.

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C. Suitability.
#analyst-notes #code-of-ethics-and-standards-of-professional-conduct #iii-duties-to-clients
Procedures for compliance

A written investment policy statement should be developed.

  • Client identification: Identify the type and nature of clients, and the existence of separate beneficiaries.
  • Investor objectives:

    • Return objectives (income, growth in principal, maintenance of purchase power).
    • Risk tolerance (suitability and stability of values).

  • Investor constraints: Liquidity needs, expected cash flows (patterns of additions and/or withdrawals), investable funds (assets and liabilities or other commitments), time horizon, tax considerations, regulatory and legal circumstances, investor preferences, circumstances, unique needs, and proxy voting responsibilities and guidance.
  • Performance measurement benchmarks.

The investor's objectives and constraints should be maintained and reviewed periodically to reflect any changes in the client's circumstances. Annual review is reasonable unless business or other reasons dictate more or less frequent review.

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C. Suitability.
#analyst-notes #code-of-ethics-and-standards-of-professional-conduct #iii-duties-to-clients
Example 1

After a five-minute interview, you advise a client how to invest a substantial proportion of her wealth. You have violated the "Know your customer" rule. You do not have adequate basis to make a detailed recommendation.

Example 2

An analyst tells a client about the upside potential, without discussing the downside risks. He violates the standard because he should discuss the downside risks as well.

Example 3

When recommending an investment to a client, an analyst mainly focuses on the characteristics of the specific investment. He violates the standard because the primary focus for determining the suitability of an investment should be on the characteristics of the entire portfolio.

Example 4

Should a firm move from a fundamental approach to selecting stocks to a more technically-based model, it would need to communicate this change to all of its current and prospective clients. Clients must always be made aware of the risk of investing as well as possible downside risks. The portfolio must always be looked at as a whole.

Example 5

The portfolio managers at DD Investing sit down with Danielle to analyze her needs and circumstances. While discussing her position with her, they find out that a wealthy cousin left her $500,000 as part of her inheritance. This triples the size of her current portfolio. As a result of the increased funds, Danielle's willingness to assume risk has increased; she can now bear more risk. Therefore, the portfolio managers should now invest more funds in the equity side of her portfolio, to increase risk and potential returns.

Example 6

A client requests to change his investment strategy from investing in North-American blue chips to emphasizing countries with high economic growth rates. The portfolio manager should explain the potential risks and returns to the client, and ask him to consider them before changing the investment strategy.

Example 7

An investment manager uses the proceeds of some high yielding securities to invest 20% of the client's portfolio in a high-risk stock, because he believes that a merger is in place and will push the price of the stock up. He will then sell the stock and repurchase other high-yielding securities. The client depends on the portfolio for her support. The manager has violated this standard, since he has not considered the effects of each transaction within the context of the entire portfolio.

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