How To Legally Invest For Others

Investing other people's money is a big responsibility and requires a great deal of ethical and regulatory knowledge. In the US, investment professionals must register with the Securities and Exchange Commission (SEC) or the state in which they operate. This involves meeting specific qualifications, passing exams, and adhering to strict ethical and professional standards.

Even if you are not a financial advisor, there are potential pitfalls to investing friends' money, including the risk of losing their money and straining relationships. It is important to establish clear boundaries and communicate about risks and expectations.

If you are considering investing for others, it is crucial to understand the legal and regulatory requirements and the potential impact on personal relationships.

Understand your client's investment profile

Understanding your client's investment profile is a key part of providing financial advice and investment management services. It involves gathering and analysing information about your client's circumstances, preferences, and objectives to ensure compliance with regulatory requirements and create suitable investment strategies. Here are some key components of understanding your client's investment profile:

• Risk tolerance and capacity: This includes the client's emotional and psychological comfort with potential investment losses (risk tolerance) and their financial ability to withstand losses (risk capacity). Risk tolerance can be shaped by the client's values, experiences, and financial goals, while risk capacity is determined by age, income, net worth, and financial obligations.
• Time horizon: Clients with a longer time horizon, such as younger investors, can typically assume more risk as returns are likely to average out over the long term. In contrast, clients nearing retirement should have a lower-risk profile to minimise the impact of potential market downturns.
• Preferences and personality: Understanding your client's preferences and personality is crucial when determining appropriate investments. For example, if a client is new to investing, complex strategies should be avoided. Additionally, advisors should know if clients have specific preferences for where their money is invested, such as environmental, social, or governance investing.
• Financial status and liquidity needs: Knowing your client's financial situation is essential for creating suitable investment strategies. Clients in higher tax brackets may benefit more from certain investments, while understanding liquidity needs can help avoid unsuitable investments with potential surrender penalties or negative pricing.
• Investment goals: Advisors should guide their clients' strategies based on their goals. For example, a young couple saving for their child's education may benefit from a specific savings plan. Understanding these goals helps build trust and allows advisors to recommend necessary adjustments to keep the investment plan on track.

Understanding your client's investment profile is a critical step in providing tailored advice and ensuring compliance with regulatory requirements. It enables financial advisors to create investment strategies that align with their clients' needs, goals, and risk tolerance, ultimately helping them achieve their financial objectives while effectively managing risk.

Reasonable basis suitability

Reasonable diligence must provide the firm or broker with an understanding of the potential risks and rewards of the recommended security or strategy. This means that the broker must conduct appropriate research and due diligence to ensure that the investment is not "designed to fail" and that it is fit to be sold to the general public. The standards for reasonable diligence vary depending on the complexity of the investment product or strategy.

For example, a broker recommending a complex investment vehicle such as a structured product would need to have a more thorough understanding of its risks and rewards compared to a more straightforward investment like a mutual fund.

In addition, a firm's policies and procedures should prohibit registered representatives from offering any type of security that has not been vetted and formally approved by the firm. The firm should also ensure that its registered representatives have completed any required training regarding the product or strategy.

By fulfilling the reasonable basis suitability obligation, brokers can help protect investors from unsuitable investments that could result in unacceptable losses or very low returns.

Customer-specific suitability

When investing on behalf of others, it is crucial to understand the concept of customer-specific suitability. This refers to the requirement that any investment recommendations made by financial professionals are suitable for the specific customer's needs, goals, and risk tolerance.

To ensure customer-specific suitability, financial advisors must gather and analyse information about their client's circumstances, preferences, and objectives. This includes assessing the client's ability to handle risk, taking into account their risk tolerance, risk capacity, and time horizon. Risk tolerance refers to the client's emotional and psychological comfort with potential investment losses, shaped by their values, experiences, and financial goals. Risk capacity, on the other hand, considers the client's financial ability to withstand losses, determined by factors such as age, income, net worth, and financial obligations. The time horizon also plays a crucial role, as a longer time horizon allows for assuming more risk, while a shorter time frame calls for a lower-risk profile.

In addition to risk assessment, customer-specific suitability also involves understanding the client's preferences and personality. For instance, if the client is new to investing, complex strategies should be avoided, and education becomes a key part of the process. The advisor needs to gauge the level of input the client wants in managing their assets. It is also important to consider the client's preferences for where their money is invested, such as their interest in environmental, social, and governance investing.

By thoroughly understanding their client's investment profile, financial advisors can ensure that their recommendations are suitable for the specific needs and preferences of each client, helping them achieve their financial goals while effectively managing risk.

Quantitative suitability

Factors that may form a basis for a finding of excessive trading or "churning" include turnover rate, cost-to-equity ratio, and the use of in-and-out trading.

To effectively supervise transactions with short-term holding periods, a broker-dealer and its supervisors must be able to distinguish between legitimate trading strategies involving these securities and excessive trading that violates the quantitative-suitability standard.

In summary, quantitative suitability requires brokers to avoid overtrading or churning their clients' accounts and to document their rationale for recommending a series of transactions to ensure compliance with FINRA regulations.

Managing expectations

When investing other people's money, it is essential to set clear expectations and maintain effective communication to ensure that everyone involved understands the risks, potential outcomes, and the impact of the investment strategy on their relationship. Here are some key considerations for managing expectations when investing for others:

Understand the Client's Investment Profile

It is crucial to thoroughly understand your client's investment profile, including their risk tolerance, time horizon, financial situation, investment goals, and personal preferences. This information will guide the creation of tailored investment strategies that align with their needs and objectives.

Communicate Realistic Returns and Risks

Be transparent about the potential returns and risks associated with the investment strategy. Avoid making unrealistic promises or guaranteeing specific outcomes. Explain that past performance does not guarantee future results, and ensure they comprehend the potential for losses as well as gains.

Set Clear Boundaries

Establish clear boundaries between your personal relationship and your professional responsibilities. Communicate that you will uphold your duties as an investment advisor, adhering to ethical and legal standards, regardless of your relationship with the client.

Discuss Conflict Resolution

Talk about how you will handle conflicts or disagreements that may arise during the investment process. Outline a clear process for addressing concerns, making decisions, and resolving issues to ensure that everyone's interests are considered and protected.

Provide Regular Updates and Reports

Keep your clients informed about the performance of their investments and any relevant market changes. Provide periodic reports and encourage open communication to address any questions or concerns they may have. This helps manage their expectations and ensures they are aware of the investment strategy's progress.

Maintain Professionalism

Treat friends and family members as you would any other client. Maintain professionalism, follow established processes, and document all interactions and recommendations. This not only protects your relationship but also ensures compliance with regulatory requirements.

Be Prepared for Losses

Discuss with your clients how you will handle potential losses. Explain that losses are a possibility and outline the steps you will take if they occur. This includes being transparent about what happened, why it happened, and the steps you will take to mitigate further risks.

Refer to Other Professionals if Needed

If you feel that managing a friend or family member's money may compromise your objectivity or create conflicts of interest, refer them to other qualified investment professionals. Recognise that maintaining your integrity and the health of your relationships may be more valuable than managing their investments yourself.

Frequently asked questions