CFP Exam 101: Everything You Need to Know to Pass the CFP Test

How Exactly Do You Stress-Test Your Financial Plan?

If you’ve been investing for some time, you most likely have a plan in place. Of course, these plans will vary depending on your specific goals, age and risk tolerance. But the essential consideration is that some sort of attainable goal, as well as a plan on how to reach that goal, is common to most investors.

Along with that, however, comes a fatal flaw that is seen far too often: These plans are made in a vacuum. You may think, if I continue earning my current salary, putting 10% in savings, and investing another 25%, then everything will turn out fine. Unfortunately, nothing happens in a vacuum — least of all in the world of investing.

The fact is that the circumstances in which you made your plan will most certainly change. Income can fluctuate (either expectedly or unexpectedly), interest rates change, inflation rises or drops, economies experience recessions, and industries crash.

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This means that our immediate cash needs and the risks associated with certain investments can significantly fluctuate, too. The way they impact our long-term financial plan is vital.

None of us can predict how the future will unfold. However, we can approximate what would happen to our portfolio if some of those initial factors were to change. The basic idea isn’t too complicated: If your primary source of income sharply decreases, will your limited savings require you to liquidate long-term investments to generate short-term cash flow, thereby throwing your entire retirement plan off course?

These are the occurrences we wish to avoid — and stress-testing our financial plan helps us do just that.

In practice, this process requires a vast amount of knowledge and expertise. Most investors turn to financial advisers to help with such a task. Whether you’re seeking to conduct this yourself, or plan to turn to a trusted adviser, the following will provide a head-start either way.

The first and most crucial aspect of a stress test is to start with a budget. Calculating your budget will allow you to forecast cash needs over time.

Understanding your cash needs — which are specific to your income, financial goals and lifestyle — allows you to recognize the most important aspect of successfully managing a financial plan over time: Your goal isn’t just about growing your assets; it’s about managing liquidity.

Life happens — and we all eventually run into unexpected cash needs. The last thing you want to do in such a situation is liquidate a long-term investment to satisfy short-term cash flow needs. This will not only divert your long-term financial plan, but you’ll likely incur added immediate expenses through capital gains taxes.

When most investors think of their financial plan, they think long-term. And that’s great — but everyone needs to be prepared for a rainy day in the immediate future. The key to finding this balance between a long-term vision and the immediate future boils down to liquidity management, which all starts with defining a budget.

If your budget isn’t clearly defined, then you’ve already botched your stress-test.

So, once you nail down a budget and projected cash flow, the focus then shifts to your portfolio. This is where things get a little tricky. Most portfolios are built using tools that only professional money managers can access. This is why it’s always best to utilize a financial adviser.

Above all, there are two primary concepts at play in your stress-test: asset appreciation and after-tax cash flow expectations. This is very similar to the strategies behind many large endowment fund managers — but just on a micro-scale.

In action, this typically involves examining risk-ratios to calculate expected returns and volatility from modern portfolio theory. The obvious goal is to maintain the lowest risk ratio for the highest expected value. A key component is maintaining balance between risk and reward, and one way in which this is done is through the Sharpe Ratio.

To put it simply, the Sharpe Ratio adjusts the expected return of an investment based on its risk. Let’s say Jerome and Sarah are both traveling from point A to point B. Jerome takes his car, averaging a modest 45 mph. Sarah takes her motorcycle, averaging 75 mph. Of course, Sarah reaches point B first. But — she also incurred much more risk than Jerome — despite the fact that they both reached the same destination.

Was the risk that Sarah took worth the benefit of arriving early? Of course, the level of risk you’re willing to assume will vary based on your unique situation, but this is the sort of insight that the Sharpe Ratio aims to illuminate.

Then, there are some stressors that need to be thrown into the mix. The most important of which should be a loss of primary income. Many experts suggest having three to six months of your salary readily accessible as cash in a savings or brokerage account. All too often however, this simply isn’t enough. More conservative savers aim for a figure closer to 12 months. Again, we see how starting with a budget — to determine monthly expenses and manage short-term cash flow needs — plays a crucial role.

For most people, the end goal of this entire process is adequately preparing for your retirement — so that you can indeed retire on time. For various reasons, the average age of retirement continues to rise, particularly for men and entrepreneurs over the age of 65. Making the choice to continue working is one thing, but feeling obligated to maintain an income stream is another. Stress-testing your portfolio will help you gain a better understanding of your preparedness to life’s curveballs — and will hopefully help you sleep better at night.

Of course, the steps above are fairly easy to understand in theory, but are much more difficult to execute in practice. Building a budget, measuring risk and assessing expected value are difficult tasks. While they are not necessarily impossible to perform on your own, the above framework — at the very least — should be used as a template when selecting a financial adviser.

One way in which financial advisers test different scenarios — and their subsequent impact on portfolios — is through the Monte Carlo Simulation.

Dwight Eisenhower once said, “Plans are nothing, planning is everything.” While the first part of that sentence might be too harsh, one is forced to agree that the actual planning is more important than the plan. Plans depend on circumstances, and circumstances change, but the ability to adapt — and construct a plan — is valuable at all times.

Monte Carlo simulations work by taking a financial plan and simulating how it would fare under different conditions; the most important of which are changes to your income and expenses, savings, your life expectancy, and expected returns from long-term investments.

Some of these factors are under your control — income, expenses and expected returns due to asset allocation largely depend on you. However, market conditions such as inflation, your investment horizon and many other factors do not. So, in order to get a result, the Monte Carlo method assigns a random value to those uncertain factors. The simulation is then run thousands of times to get a probability distribution.

If this sounds complicated, there’s no need to worry. Even if you’re an experienced investor, this is a topic that requires professional experience in the field. The fact is, even if the software used to run stress-tests were available to the general public (which it isn’t), you would still be left with the trouble of deciphering the results of the test and putting them to use.

It’s an arduous task to stress-test a financial plan on your own. Leveraging a professional is the most popular path here. You can, however, do some prep work yourself to better understand the process and select a financial adviser you trust. Most of those preparations will revolve around budgeting and making contingency plans for yourself — think of them as your own prelude to a stress-test.

This article was written by and presents the views of our contributing adviser, not the Kiplinger editorial staff. You can check adviser records with the SEC or with FINRA.

How to Find a Financial Advisor Practice to Buy

Buying a financial advisor practice could be a wise investment if you’re interested in scaling an existing business. If the purchase includes a stable client base, that could open the door to an increase in your revenues. Likewise, you might consider acquiring a practice if you’re just getting started and want to hit the ground running with already clients in place. As you’re researching how to buy a financial advisor practice, consider using SmartAdvisor to connect with prospects locally.

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Why Do Financial Advisors Sell a Practice?

There are a number of reasons why an advisor might choose to sell their practice. One of the most common is that they’ve decided to retire.

When an advisor is ready to retire, they may have a few options for passing the business on. For example, if the practice is family-run, the reins of ownership and management may be handed over to one of their children or siblings. If there’s no one to succeed them internally, then an outright sale may be the next best option.

The decision to sell can be motivated by factors other than retirement. An advisor who’s experiencing an ongoing health issue that prevents them from fully meeting their clients’ needs may be inclined to sell to someone who can. Advisors may also choose to sell if they’re pivoting their business in a different direction or are pursuing an entirely new career path.

Of course, it’s always possible that an advisor may be looking to sell if the business is struggling and they’re ready to walk away. Understanding some of the reasons why an advisor might sell is important if you’re hoping to buy a practice. Having that background knowledge is helpful for gauging whether a deal is a good investment.

How to Buy a Financial Advisor Practice

Buying an existing practice is a fairly straightforward transaction, but it’s helpful to know what to expect. It’s also important to assess how buying a practice might benefit you and what risks, if any, it might involve.

This checklist can help you better prepare for buying an advisory practice.

Review Your Finances

Before you begin looking for a practice to buy, start with an exam of your finances. Here are some of the most important questions to ask:

These questions are designed to give you a sense of what’s realistic now and going forward. It’s also a good idea to consider how much of a loss you might be able to sustain if the purchase doesn’t go as planned. For example, if your newly acquired clients decide that they’d rather go elsewhere, that can directly affect your return on investment in the business.

Research the Practice’s Financials

Once you’ve taken a closer look at your finances, the next step is to dig into the financial details of the practice that you hope to buy. Some of the questions to ask at this stage include:

Essentially, you want to know two things here: how the company makes money and where that money goes.

If there’s no recent appraisal available, you may want to have one done yourself. Having an appraisal in hand can give you a better idea of the business’s value, which is helpful when deciding how much to offer. If any practice that you’re interested in buying is reluctant to share financial details or estimates of value, that could be a red flag that it’s struggling.

Look Into the Company Culture

Understanding the culture of an advisory practice can tell you a lot about how it treats its employees and its clients. Here are a few things to consider that can give you a better idea of how a company operates:

Talking to employees is a good way to get insight into how the company works and what the culture is like. It can also be an opportunity to reassure employees that you’re committed to preserving that culture as much as possible should you decide to purchase the business.

If you find that a practice’s culture is completely different from yours, that could make the transition more difficult for employees and clients. In that scenario, it’s important to consider how much turnover you could reasonably afford on either side if you were to buy the practice.

Work Out the Legal Details

Once you’ve found a practice that you’d like to purchase, you’ll need to jump through the various legal hoops required to seal the deal. Hiring an attorney who’s experienced in the sale and purchase of existing businesses can ensure that this part of the process goes as smoothly as possible.

For example, you’ll need to agree on the purchase price and completion date for the acquisition. You’ll also need to work out exactly what’s included with the purchase and what steps may be necessary to retitle any business assets you’re taking ownership of.

Finally, the advisor who’s selling should arrange an introduction for you with staff and clients. That’s an opportunity for you to get to know them a little better and offer reassurance about what they can expect going forward.

How to Find a Financial Advisor Practice to Buy

If you’re in the market to buy an advisory practice, there are a few ways to go about finding one to purchase. Here are some of the possibilities you might consider:

Bottom Line

Buying a financial advisor practice could make sense if you’re hoping to expand or you’re looking for a turnkey business, rather than trying to build your own firm from the ground up. Knowing what’s typically involved — and what the biggest risks are — can help you to decide if this kind of investment is right for you.

Tips for Growing Your Financial Advisory Business

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