CFP Module 2 key terms

The principle that a sum of money available today is worth more than the same sum received later, because today's money can be invested to earn a return. It underpins nearly all financial planning calculations.

The value today of a future sum or stream of payments, after removing the effect of interest earned over time. Planners use it to compare goals, pensions, and lump-sum offers on a common footing.

The rate used to reduce future cash flows to their present value. It reflects the opportunity cost of money and, for risky cash flows, a premium for uncertainty. Choosing it correctly drives planning accuracy.

Interest that is calculated on both the original principal and previously accumulated interest, so growth accelerates over time. The frequency of compounding (annual, monthly, daily) affects the effective return.

The return on an investment after subtracting inflation, showing the change in purchasing power. Planners use it to set realistic long-term growth assumptions for goals measured in today's dollars.

A summary of a client's income and outflows over a period, used to identify surplus or deficit and to fund savings goals. It is a core data-gathering tool in the financial planning process.

A snapshot listing a client's assets and liabilities at a point in time, with the difference being net worth. It reveals leverage, liquidity, and progress toward long-term financial goals.

Readily accessible savings set aside to cover unexpected expenses or income loss, typically three to six months of essential outlays. It protects long-term investments from forced selling during setbacks.

A client's emotional and psychological willingness to accept investment volatility and possible loss. It differs from risk capacity, which is the financial ability to absorb loss without derailing goals.

The financial ability to withstand investment losses without compromising essential goals, driven by time horizon, income stability, and liquidity needs. A client may tolerate more risk than they can actually afford.

The division of a portfolio among asset classes such as equities, bonds, and cash. It is the primary driver of long-term return and volatility and should follow from goals, horizon, and risk profile.

Spreading investments across assets, sectors, and regions so that no single loss dominates the portfolio. It reduces unsystematic risk but cannot eliminate market-wide systematic risk.

Market-wide risk that affects all securities and cannot be removed by diversification, such as interest rate or recession risk. Investors are compensated for bearing it through higher expected returns.

A measure of how much a security or portfolio moves relative to the overall market. A beta above one implies greater volatility than the market; below one implies less. It captures systematic risk.

A statistical measure of how widely returns vary around their average, commonly used as a proxy for investment volatility and total risk. Higher values signal a wider range of possible outcomes.

A risk-adjusted performance measure calculated as excess return above the risk-free rate divided by standard deviation. It shows how much return was earned per unit of total volatility taken.

The return on an investment assumed to carry no default risk, usually proxied by short-term government securities. It serves as the baseline against which risky investments are compared.

Periodically buying and selling holdings to restore a portfolio to its target asset allocation after market movements shift the weights. It enforces a disciplined sell-high, buy-low discipline.

A written document setting out a portfolio's objectives, constraints, target allocation, and review procedures. It guides decisions during market stress and clarifies responsibilities between planner and client.

The total return an investor earns by holding a bond to maturity, assuming all coupons are reinvested at that same rate. It links a bond's price, coupon, and remaining term into one figure.

A measure of a bond's price sensitivity to interest rate changes, expressed in years. A duration of five implies roughly a five percent price move for each one percent shift in rates.

The risk that rising interest rates will reduce the market value of fixed-income investments and other rate-sensitive assets. Longer duration and lower coupons generally increase this exposure.

The danger that general price increases erode the real purchasing power of savings and investment returns. It hits cash and fixed-income holdings hardest over long horizons.

The ease and speed with which an asset can be converted to cash without a significant price concession. Illiquid assets may suit long horizons but can jeopardize short-term goals and emergency needs.

A retirement plan in which the employer promises a specified benefit, usually based on salary and years of service, and bears the investment risk. Payouts may be lifetime annuities.

A retirement plan in which the employer contributes to an individual account and the employee bears investment risk, with the balance depending on contributions and returns. Examples include profit-sharing and money purchase plans.

The process by which an employee earns a non-forfeitable right to employer contributions or benefits, often on a graded or cliff schedule. Unvested amounts are lost on leaving employment.

The minimum amount that must be withdrawn annually from most tax-deferred retirement accounts once the owner reaches the required age. Failing to withdraw triggers a substantial excise penalty.

The accumulation of investment earnings without current taxation, with taxes postponed until withdrawal. The deferral lets compounding work on a larger balance over time.

The proportion of pre-retirement earnings that Social Security benefits replace, typically higher for lower earners. It helps planners estimate the gap that personal savings must fill.

The percentage of a retirement portfolio drawn each year to fund spending. Setting it too high raises the risk of depleting assets during a long retirement, especially with poor early returns.

The danger that poor investment returns occurring early in retirement permanently impair a portfolio, even if average returns over the whole period are acceptable. Withdrawals during downturns magnify the damage.

An employer-sponsored retirement plan that meets tax code requirements and therefore receives favorable tax treatment, such as deductible contributions and tax-deferred growth. It must follow nondiscrimination and reporting rules.

The court-supervised process of validating a will and distributing a decedent's assets. Assets passing by beneficiary designation or joint ownership generally avoid it, saving time and cost.

A legal document directing how a person's probate assets are distributed after death and naming a guardian for minors. It must meet formal execution requirements to be valid.

Dying without a valid will, so that state law determines how assets are distributed. The result may not match the deceased's wishes and can cause family conflict.

A contract provision naming who receives an account or policy on the owner's death, typically overriding the will. Keeping designations current is essential to avoid unintended outcomes.

A legal arrangement in which a trustee holds and manages assets for the benefit of named beneficiaries according to the trust's terms. Trusts can control distribution timing and may avoid probate.

The person or institution legally responsible for administering a trust, including investing assets and distributing them per the trust document. Fiduciary duties of loyalty and prudence apply.

A document authorizing an agent to act on another's behalf in financial or legal matters, either immediately or on incapacity. A durable version survives the principal's incapacitation.

The rate applied to the next dollar of taxable income, which determines the tax saving from a deduction or the tax cost of extra income. It differs from the average tax rate.

Profits from selling an asset above its cost basis. Long-term gains generally receive preferential rates, while short-term gains are taxed as ordinary income in many systems.

The original value of an asset for tax purposes, adjusted for improvements, dividends reinvested, or depreciation. Gain or loss on sale is measured against it.

A tax rule that resets the cost basis of inherited assets to their value at the date of death, reducing capital gains for heirs. It makes holding appreciated assets until death attractive.

A legal obligation to act in another party's best interest, placing the client's interests ahead of the adviser's own. It requires loyalty, disclosure of conflicts, and prudent care.

The standard requiring that a recommendation be reasonably appropriate for a client's objectives, finances, and risk profile. It is generally less stringent than a fiduciary best-interest standard.