FINRA Exam Suitability

In this article we are going to  examine the recommendation process and review how recommendations are made to customers.  We will also analyze whether or not recommendations are suitable for the customers based on their particular situation. All recommendations must be suitable. The registered representative, when evaluating a customer’s financial status, investment objective, and other considerations must bring recommendations and investment ideas to the customer that meets their investment objective.

A registered representative’s suitability obligation is triggered when the registered representative starts talking about an investment to a customer. This means that if an investment does not meet the client’s profile it should not be discussed.  For example, if you have Widow Jones as a client, and she is conservative, and she is risk averse, you shouldn’t start having a conversation with Widow Jones about Bitcoin or S&P options. These investments are far, far too risky for this type of individual.

Looking at this another way and taking it a step further, whatever you present to the customer must meet their investment objective. And when you’re comparing different investment options for the customer, all of those choices must meet their investment objective.

Any time you make a recommendation for a customer to put money into an investment, the recommendation must be stated as a belief not as a fact. . See if you can determine the difference between these two statements..

A registered representative is having a conversation with a client and recommends XYZ. The customer says, well, what are the good things about XYZ? And he  mentions a few of the highlights. And says, the stock price is going to go a lot higher.

That’s one statement. “The stock price is going to go a lot higher.” That statement sounds like a fact. Let’s contrast that with the registered rep saying, well, we have a price target on this stock that is substantially higher. Those are two statements that a registered rep could make about a potential investment.

The statement “XYZ is going to go a lot higher” is a fact. We have a price target on the stock, which is substantially higher, indicates that it is a belief. It is not a statement of fact. It is not certain, and that second statement is far more appropriate as a result.

If a firm or registered representative is going to refer to their past recommendations, certain disclosures must be made.  The items that must be disclosed include:

1) The date when you made the recommendation.

2) The price when you made the recommendation. 

3) A disclosure regarding the market conditions as time has passed.

There also has to be disclosure that past performance is no guarantee of future results. Just because we got it right on these past recommendations, doesn’t mean we’re going to get it right on the next recommendations. All of your dealings with customers should be fair and equitable and based on honest principles of trade. Making sure that your recommendations are suitable for your customer’s situation is  the foundation of this concept.

FINRA rules require registered representatives to “Know your customer”. This is an important part of the relationship  between the representative and the customer. The exam is going to want to make sure you understand how to match investments with the customer’s situations, and understanding the customer’s situation and mindset is going to go a long way to helping you do that. Certainly, you should know about their  Investment objectives.

Everybody wants to make money, but everyone does not want to make money in the same way.  is the client looking to make money through income or through growth? Two very different ways to make money.  the registered representative should ask enough questions to develop a client profile. Some of the questions a registered representative should ask include the following:

1) How long has  the client been investing in securities?

2) What is the client’s financial status? 

3) What Is the client’s level of income ?

4) What type of tax considerations or tax status do we need to be aware of? 

5) How much money does the client have invested in the market?

6) Any big financial obligations coming up like college tuition for children? 

7) What is the client’s  attitude towards investing? 

Does the client think Wall Street is gambling, or does the client  think buying stock is a great way to build wealth? These will really dictate the person’s belief about what they’re doing with their money.

Other considerations that need to be taken into account are things like the age of the investor. Certainly, if they’re 30  years old, they can take more risk than if they’re 70 or 80 years old. So how old they are is important. Is the client married? Does the client have children? This all goes to the financial profile, and creates the financial picture of the client. All of these factors when taken into consideration are used to develop recommendations and investment opportunities for the client.

Specific factors relating to the  stability of the client’s employment and income  must be taken into consideration. A registered representative should ask the client questions such as: 

How long have you been at your current job? 

Is your job picture stable?

 A client who has been at their job for a long period  of time is in a much better position than a client whose employment has changed multiple times over a short number of years.

Most investors have saving for retirement as part of their investment strategy. A registered representative when speaking with a client should inquire as to when the client is looking to retire.  The registered representative should ask questions such as : When do you plan to retire? How far away is that? it is important to keep this in mind when making a recommendation to a customer.

On your exam, an interesting situation can arise when FINRA details a conversation with a client, and they do not want to provide a substantial amount of financial information to you. And they’re asking you to make a recommendation for this customer. Can you do it?

Well, the answer is maybe. Now, let’s see if we can pinpoint when you can make a recommendation and when you should withhold  making a recommendation. If a customer says to you, I have a net worth of $3 million. I’m not providing any more information to you. I have a growth objective. What do you think looks good?

The representative then  inquires if the client has any financial liabilities. The client responds that they have no financial liabilities and provides no further details to the representative. That should be enough to help you determine suitability. However, If a customer puts $20,000 into a brokerage account and says they don’t want to provide you with any information, well, here you have a problem. This $20,000 could be their pocket money or could be their life savings. In that scenario, you should withhold making a recommendation.

If they make you or force you to make a recommendation on the ABCD answer key, your answer would be a money market fund. Because it is the most stable, most secure, and has the least risk associated with that investment. For that individual, you may also be allowed to accept unsolicited orders.

With an unsolicited order the representative is not making a recommendation. when a customer calls up and asks the representative to execute in order on behalf of the customer, the representative may not refuse the order. the representative must execute the order even if  the representative thinks the order is unsuitable.

Now, let’s see if we can match some of the investments or securities to the different types of investment objectives a client may be presented with for your exam. So if your customer has an income objective, the customer wants to receive current income Suitable recommendations would include:

  •  corporate bonds
  •  preferred stock
  •  bond funds
  •  preferred stock funds

All of these Investments will generate income for that income-oriented investor. If a customer wants capital appreciation or growth,  there are only two Investments on the planet that will meet a growth objective. Those Investments are common stock or a common stock fund 

If a customer has a safety of principal objective. It means they don’t want to lose their money. They’ve worked hard and want to make sure they don’t lose it. The most highly rated bonds available in the answer key will be your best answer– T notes, T bills, T bonds. Money market funds would be the absolute safest. That would provide the person with the greatest safety of principal.

The money market fund would not subject  the investor to any market losses. If a money market fund is not there, you would look for the T bills, T notes or T bonds, and in that order. Because the T bills will have a lower risk of price fluctuation during their term. And the T bonds would have a greater risk of price fluctuation. Other acceptable choices may  include highly rated corporate bonds and municipal bonds. 

If a customer needs liquidity, it means the customer wants  to be able to access their money. If the test gives you a scenario where you meet with a young couple, and they’ve saved $40,000 for the down payment for a house that they want to buy in three years or so. And the question asks you to make a recommendation to these people, your answer is  a money market fund. The money market fund is the best recommendation because they need access to that money, meaning they need liquidity– and they don’t want it to fluctuate. That’s the best choice in that scenario. 

Common stock bonds and mutual funds are also very liquid. But the money market is Your answer for test purposes. 

An investor who is seeking tax relief is looking for investment that will not add to their taxable income.The customer wants to take advantage of an investment that will not create additional federal income tax liability. So for this  investment objective a portfolio of municipal bonds or municipal bond funds would be the only appropriate recommendations.

An investor who is looking to speculate or who has  an investment objective of speculation is willing to take on a lot of risk in exchange to try and achieve superior growth or a lot of reward. Penny stocks, junk bonds, small cap stocks– all have large, large capital appreciation potential. But they also have a lot of risk.

Understanding the investor’s investment objective is only part of making a suitable recommendation. In order to ensure that the investment meets the Investor’s objective a registered representative must have a complete understanding of the risks associated with investing in securities. As part of the suitability determination process we will now examine some of the risks associated with investing in securities.

Capital risk: Capital risk is the risk that an investor may lose all or part of  the money placed into the investment. You could buy a stock at 20, and it goes to zero. You lost all of your capital. That is capital risk.

Market risk: Market risk is also known as systematic risk. You could own stock in the best company on the planet, and the company may be making more money than it ever has. But the stock price is going down simply because the stock market is going down.

You can’t diversify out of systematic risk. It’s the risk inherent in any investment in the market. You could own the best company in the world, but when large investors sell, they sell indiscriminately and everything goes down. So you cannot diversify out of systematic risk. 

Non-systematic risk: is the risk that is inherent in one industry or with one company. For example, a situation that may arise and impact the drug industry isn’t going to impact the technology industry. They have nothing to do with each other. So rather than buying two companies in the pharmaceutical industry, maybe buy one company in the pharmaceutical industry, and buy the stock of one company in the technology industry thereby diversifying out of that non-systematic risk.

Legislative risk: is the risk that the government will do something that adversely impacts your investment. Well, the government tends to go after different industries from time to time, whether it’s the banks, the drug makers, the coal companies, whoever it is. If they enact legislation that will adversely impact companies in that industry, that is legislative risk.

Some years ago, they started going after the coal industry. Why? Because they thought coal was not great for the environment. And people who owned stock in coal companies ended up suffering significant losses simply due to legislative risk. If the government started to make rules and regulations around the pharmaceutical industry, well that will hurt the pharmaceutical companies. That again would be an example of legislative risk.

Call risk: Call risk, again, is only inherent in a security that may be called. And the only two types of securities that you will see on the exam that could be subject to call risk are a callable bond and a callable preferred stock. If there’s no call feature on the investment, the investor is not subject to call risk. A preferred stock or a bond that is callable will be called when interest rates go down. So when the issuer calls in that preferred stock or that bond, the investor is going to be forced to reinvest the proceeds at a lower rate and that is call risk.

Reinvestment risk: As  high quality, high yielding bonds mature, investors are going to realize reinvestment risk when interest rates have fallen. If  an investor had a AAA-rated bond paying 8%, and interest rates had fallen to 6% on AAA bonds. Well, the investor receives the principal payment when the high rated, high yielding bond matures. Now the investor is no longer able to receive 8% on a AAA bond.

The investor has two choices. One,  they can accept the 6% on the AAA-rated bond, or or they walk further out on the risk curve, and you buy a lower quality, higher risk investment that will offer perhaps 8%. Now, as long as those interest payments come in, the investor is OK. But  the investor is not in the same place since they have taken on more risk to get the same 8% interest rate.

Credit risk.:Credit risk is only associated with bonds or other debt instruments. It’s the risk of default. The company said they’d pay you, but they are unable to do so because of their lack of funds. And that is credit risk.

Timing risk: is the risk that you’re going to buy and sell securities at the wrong time, and as a result, suffer losses. You’re going to buy high and sell low rather than buy low and sell high.

Liquidity risk: Liquidity risk impacts an investor who has a relatively large position in a stock that doesn’t trade very many shares in any given day, week, or month. Let’s say an investor had 10,000 shares of a stock, and that stock trades 50,000 shares a day. If the investor wanted to sell that entire 10,000 shares in one day, it would drive the stock price significantly lower. That is liquidity risk. The risk that you cannot get in or out of your investment without adversely impacting the price of that investment.

Making recommendations to institutional customers is somewhat different than making a recommendation to an individual or a retail style customer. When you make a presentation to an institutional customer, you can pretty much recommend anything you want to the institutional customer. And they can evaluate whether it’s suitable for themselves, because of their high level of sophistication.

Now, a scenario can arise when a registered representative is talking to an institutional customer and realizes the person on the other end of the phone doesn’t understand the investment opportunity the registered rep is discussing.

What happens in that scenario? Well, in that scenario, the suitability determination reverts back to the registered rep and the broker dealer. If the institutional customer doesn’t understand it, the registered rep has to determine whether or not it’s suitable for that institution.

Recommending mutual funds: When you’re recommending mutual funds to an investor, it’s important not to mislead the customer. Now, when making Recommendations to the customer about a mutual fund, you have to base those recommendations using the highest sales charge charged by the fund. You can’t discuss a return or a yield based on a breakpoint schedule.

Additionally, any discussion of the yield or the income generated by the fund must be based only on dividend distributions. You can’t include that capital gain distribution, because those can’t be counted on as much as the dividend income.

We hope that this article has helped you gain a better understanding of suitability and customer recommendations for your upcoming FINRA exam.

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 Good luck on your exam!

 The Securities Institute of America

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