Ethics and Standards - Standard V-A: Diligence And Reasonable Basis

Standard V has three subsections:

  • Standard V-A: Diligence and Reasonable Basis
  • Standard V-B: Communication with Clients and Prospective Clients
  • Standard V-C: Record Retention

Standard V-A: Diligence and Reasonable Basis_____________

Members and Candidates must:

1. Exercise diligence, independence and thoroughness in analyzing investments, making investment recommendations and taking investment actions.

2. Have a reasonable and adequate basis, supported by appropriate research and investigation, for any investment analysis, recommendation or action.

Reasoning behind Standard V-A
It's an all–too-common practice for a participant in the investment industry to pass a "hot stock tip" onto clients. While some professional practitioners will research and investigate such ideas before recommending them to clients, many others simply pass along that information as a way of keeping in contact with clients who have a high net worth and prompting additional trading action (on which the broker collects commissions). For the creators of the Standards of Professional Conduct of the CFA Institute, Standard V-A, Diligence and Reasonable Basis, is designed to reduce and eliminate such practices. Moreover, and partly as a result of the Standards promoted by the CFA Institute and other regulatory bodies, the investing process is much more highly developed today when compared to the Standards from years ago. The specific techniques and methods developed to practice investment research have been encouraging to those who believe that such analysis leads to better recommendations and better performance for clients.

To be sure, hot stock tips still have their proponents and practitioners – just watch any cable channel devoted to financial and business news. For most of us, there's some intrigue to playing "buy, sell or hold" on one of these programs and asking a leading analyst for a 30-second soundbite on a company. The internet chat rooms that provide a forum for discussion among day traders will continue to proliferate, and in the case of some sectors (usually small caps and IPOs, usually technology), these forums can offer immediate ideas for a portfolio manager. The basic premise of this Standard is that the market has always been filled with ideas that can be acted upon immediately. An idea is not the same as a recommendation – it takes a process to go from idea to recommendation.

This Standard recognizes that many investment professionals are not directly involved in the investment process. Perhaps they are primarily involved in the client relationship effort, and within that client relationship, specific portfolio transactions are recommended.

To avoid a violation, professionals' recommendations should be based on:

  • their own firm's research
  • another person's research, where conclusions are based on research complying with this Standard (diligence, thoroughness)
  • research prepared for general distribution by a bank or brokerage
  • quantitative methods, such as computer stock screens or ranking models based on fundamental criteria

Key Points to Remember about Standard V-A

  • Exercise diligence in investigating the accuracy of a research report being used as the basis for a recommendation. The market is filled with worthwhile research and with substandard research – years of experience are needed to learn to distinguish between the two. Quantitative conclusions are usually predicated on the quality of the data and the size of the sample, while fundamental research will vary depending on the methodology of the individual writing the report.
  • For recommendations to buy or sell foreign securities, consider the differences between foreign and domestic standards. Particularly in emerging markets, the extent of corporate disclosure can be minimal, and accounting standards are often rudimentary, with typical ratios such as debt level and net profit margin being difficult to compare to an industry peer in a domestic market. Moreover, securities regulations do not serve to protect the investor to the same extent as in mature markets. Liquidity can be sparse, and currency fluctuations can affect performance.

Applying Standard V-A

  • Be sensitive to business considerations. If the need to diligently research and gather information to investigate a company conflicts with an ongoing business relationship with that firm, an analyst may need to balance those conflicting responsibilities, and (if necessary) point out where necessary information could not be obtained.
  • Is the research using a best-case scenario in a business situation as if it were the average or expected scenario? This is a common technique to justify a buy recommendation, but it essentially violates the misrepresentation tenet of the Standard. Research is considered higher quality when it presents a range of possible scenarios.
  • Recommendations disseminated in internet chat rooms or on cable TV shout-fests are not considered compliant with this Standard. CFA charterholders are not precluded from participating in such forums, but the nature of this Standard is to require diligence and thoroughness and to require records to be created and retained. Moreover, it is difficult to fact-check this information to verify misrepresentations.

How to Comply
To summarize, the following areas should be the primary focus:

  • The Security - Each research process is likely to be unique, but whatever the particular basis for a specific recommendation might be, it should generally be consistently applied to the company's history of recommendations. Many research shops employ a general template of information that is always to be included with a recommendation (e.g. a summary of specific business factors, important financial statistics and ratios) to help guide compliance and ensure that the analyst employs a consistently diligent effort.
  • The Portfolio - Is this security (and its expected level of risk) appropriate for all portfolios, or is it too risky for some, or perhaps not aggressive enough for others? CFA charterholders and candidates are obligated to examine the needs and circumstances of the clients on an ongoing basis, not just when the account opens. Portfolio theory emphasizes the need to diversify as a tool for reducing risk; thus any approach that concentrates a portfolio in just a couple of investments may not be in compliance.
  • The Records - The importance of maintaining a complete track record of reasons for investment decisions is reinforced by the need to make this requirement a separate Standard in the revised list that becomes effective in 2006 (please refer to Standard V–C). Files can establish a paper trail and help protect the manager from accusations that a certain security (should it turn out badly) was not bought with an adequate basis and rationale.
Standard V-B: Communication With Clients And Prospective Clients
Related Articles
  1. Financial Advisors

    Tips on Passing the CFA Level I on Your First Attempt

    Obtain valuable tips and helpful study instructions that can help you pass the Level 1 Chartered Financial Analyst exam on your first attempt.
  2. Financial Advisors

    Putting Your CFA Level I on Your Resume

    Learn techniques for emphasizing your CFA Level I status in the Skills and Certifications or Professional Development section of your resume.
  3. Professionals

    Investment Analyst: Career Path and Qualifications

    Learn how to prepare for a career as an investment analyst, and read more about how many professionals in the field progress during their careers.
  4. Professionals

    CAIA Vs. CFA: How Are They Different?

    Find out how the CAIA and CFA designations differ, including which professionals should seek either title based on their career ambitions.
  5. Professionals

    Equity Investments: CFA Level II Tutorial

    Chapter 1: Equity Valuation: Its Applications and Processes Chapter 2: Return Concepts for Equity Valuation Chapter 3: Industry Analysis With Porter's 5 Forces
  6. Professionals

    What To Expect On The CFA Level III Exam

    The Chartered Financial Analyst Level III exam, which is only offered in June, is the last in the series of three tests that CFA candidates must pass.
  7. Professionals

    What To Expect On The CFA Level I Exam

    Becoming a chartered financial analyst requires the passing of three grueling exams covering an array of topics.
  8. Options & Futures

    The Alphabet Soup of Financial Certifications

    We decode the meaning of the many letters that can follow the names of financial professionals.
  9. Professionals

    How to Ace the CFA Level I Exam

    Prepare to ace the CFA Level 1 exam by studying systematically.
  10. Personal Finance

    How To Choose A Financial Advisor

    Many advisors display similar skillsets that can make distinguishing between them difficult. The following guidelines can help you better understand their qualifications and services.
  1. Personal Financial Advisor

    Professionals who help individuals manage their finances by providing ...
  2. CFA Institute

    Formerly known as the Association for Investment Management and ...
  3. Security Analyst

    A financial professional who studies various industries and companies, ...
  4. Chartered Financial Analyst - CFA

    A professional designation given by the CFA Institute (formerly ...
  1. What are the differences between a Chartered Financial Analyst (CFA) and a Certified ...

    The differences between a Chartered Financial Analyst (CFA) and a Certified Financial Planner (CFP) are many, but comes down ... Read Full Answer >>
  2. How do I become a Chartered Financial Analyst (CFA)?

    According to the CFA Institute, a person who holds a CFA charter is not a chartered financial analyst. The CFA Institute ... Read Full Answer >>
  3. What types of positions might a Chartered Financial Analyst (CFA) hold?

    The types of positions that a Chartered Financial Analyst (CFA) is likely to hold include any position that deals with large ... Read Full Answer >>
  4. Who benefits the most from prepaid expenses?

    Prepaid expenses benefit both businesses and individuals. Prepaid expenses are the types of expenses that are bought or paid ... Read Full Answer >>
  5. If I am looking to get an Investment Banking job. What education do employers prefer? ...

    If you are looking specifically for an investment banking position, an MBA may be marginally preferable over the CFA. The ... Read Full Answer >>
  6. Can I still pass the CFA Level I if I do poorly in the ethics section?

    You may still pass the Chartered Financial Analysis (CFA) Level I even if you fare poorly in the ethics section, but don't ... Read Full Answer >>
Hot Definitions
  1. Take A Bath

    A slang term referring to the situation of an investor who has experienced a large loss from an investment or speculative ...
  2. Black Friday

    1. A day of stock market catastrophe. Originally, September 24, 1869, was deemed Black Friday. The crash was sparked by gold ...
  3. Turkey

    Slang for an investment that yields disappointing results or turns out worse than expected. Failed business deals, securities ...
  4. Barefoot Pilgrim

    A slang term for an unsophisticated investor who loses all of his or her wealth by trading equities in the stock market. ...
  5. Quick Ratio

    The quick ratio is an indicator of a company’s short-term liquidity. The quick ratio measures a company’s ability to meet ...
  6. Black Tuesday

    October 29, 1929, when the DJIA fell 12% - one of the largest one-day drops in stock market history. More than 16 million ...
Trading Center