Monday, October 15, 2012

Series 7 Sample Question - Suitability

Our Pass the 7 ExamCram Online Test Prep now has a quiz called "Suitability of Customer Recommendations." It is up to 35 questions, and I hope to double that number ASAP. For now, let's do a practice question that forces the test taker to show the test he or she knows the different types of mutual funds. Here goes:

Your customer is a 66-year-old recently retired school teacher living on a defined benefit pension. Her monthly check from the teacher's retirement system covers her expenses, but she also remembers the rampant inflation of the 1970's and is afraid her pension income won't keep up with rising prices. She also foresees some major home repairs in the future, none of which is critical for probably 5 - 7 years. Which of the following funds seems LEAST suitable given her needs?
A.equity income fund fund
C.balanced fund
D.large cap value fund 

Don't assume that "66-year-old retired teacher" is code for "pick something really conservative." No, this investor already has something really conservative--a defined benefit pension check coming every month for as long as she lives. Her income piece is pretty well covered, but she worries about inflation and needs to build up some capital to be used for home repairs 5-7 years out. That means she has to be in the stock market. It also means she can' afford to be super aggressive, not over a 5-7-year time horizon. An aggressive growth investor would need a 10-year-plus time horizon because when it's time to put a new roof on the house, it's just not acceptable for the investor to sell when her investment is temporarily down 40%. And that scenario is quite common in the world of aggressive growth stocks and mutual funds. On the other hand, this question doesn't present any aggressive investments, so at first it's hard to see how any of them would be less than suitable. But, if we hold fast to the idea that she needs to be in the stock market to protect her purchasing power, possibly receive a higher income stream down the line, and build up some capital for a 5-7-year goal, we see that only one of these choices does not provide access to the stock market. By definition, a bond fund is not about the stock market, right? An equity income fund is mostly about stocks and about finding issuers that pay ever-rising dividends. A balanced fund always has a large % in the stock market, and always in a well-diversified, conservative allocation. A large cap value fund is comprised of large companies that are currently trading on the cheap--meaning, high dividend yields a-plenty. So, again, the one that is not in the stock market is LEAST suitable--the bond fund, ANSWER B. Practice Questions Online


  1. now up to 40 questions . . . will try to make it 50 by el fin de semana, clase.

  2. also: bonds are not expected to pay INCREASING income streams. By definition, they are fixed-income streams. A rising income stream comes from common stock (maybe) or participating preferred stock.