What does FINRA say about suitability?

For a deeper understanding of your new suitability requirements (after passing your exam, of course, and getting registered) please check out what FINRA has to say about the topic at http://www.finra.org/web/groups/industry/@ip/@reg/@notice/documents/notices/p123701.pdf

For example, aren't we all kind of curious to know the answer to this question?


Would a firm violate the suitability rule if it makes recommendations to customers
for whom it has not obtained all of the customer-specific information listed in FINRA
Rule 2111?

Studying for Series 7?

Risk Tolerance

So, an investor might have the primary objective of growth/capital appreciation. He may also have a time horizon of 20 years. However, if he doesn’t have the risk tolerance required of the stock market, we have to keep him out of stocks. Remember that risk tolerance has to do with not only the financial resources, but also the psychological ability to sustain wide fluctuations in market value, as well as the occasional loss of principal that makes investing so much fun in the first place. The terms “risk-averse,” “conservative,” and “low risk tolerance” all mean the same thing—these investors will not tolerate big market drops. They invest in safe, boring things like fixed annuities, US Treasuries, and investment-grade bonds. In order to invest in sector funds or emerging market funds the investor needs a high risk tolerance. Moderate risk tolerance would likely match up with balanced funds, equity income funds, and conservative bond funds.

Putting the three together (investment objectives, time horizon, risk tolerance), then, if we know the investor in the question seeks growth, we then have to know his time horizon and risk tolerance. If he’s a 32-year-old in an IRA account, his time horizon is long-term. Unless he has a low risk tolerance you would almost have to recommend growth funds. If the investor is 60 years old and living on a pension income, she might need to invest in common stock to protect her purchasing power. If so, her time horizon is long, but maybe her risk tolerance is lower than the 32-year-old's. So, we’d probably find a conservative stock fund—not a small cap growth or “international discovery” fund—maybe a growth & income or equity income fund. If another investor seeks income primarily, we need to know her time horizon and risk tolerance. We don’t buy bonds that mature beyond her anticipated holding period. If she has a 10-year time horizon, we need bonds that mature in 10 years or sooner. Her risk tolerance will tell us if we can maximize her income with high-yield bonds, or if we should instead be smart and buy investment-grade bond funds. If she needs tax-exempt income, clearly, we put some of her money into municipal bond funds. For capital preservation nothing beats US Treasury securities. GNMA securities are also very safe. Money market mutual funds are safe—though not guaranteed by the US Government or anyone else—but they pay low yields. Money market mutual funds are for people who not only want to preserve capital but also make frequent withdrawals from the account. See, even though your money is safer in a 30-year Treasury bond than in a money market mutual fund, the big difference is that the market price of your T-bond fluctuates (rates up, price down), while the money market mutual fund stays at  $1 per share.

Seriously. So if liquidity is a major concern, the money market mutual fund is actually better than T-bonds, T-notes, and even T-bills, all of which have to be sold at whatever price. With the money market mutual fund, you can write checks, and the fund company will redeem the right number of shares to cover it.

Total liquidity. And totally boring, just as many investors like it.Suitability Questions for Series 7

Big 3: Objectives, Time Horizon, and Risk Tolerance

When presented with a suitability question on the Series 7 Exam, try to think as you will once you get your license. First, what are the goals of the investor? What are her investment objectives? Investment objectives include: capital preservation, income, growth & income, growth, and speculation. If the individual is in his 30’s and is setting up a retirement account, he probably needs growth to build up his net worth before reaching retirement age. If he’s already in retirement, he probably needs income. He might need income almost exclusively, or, to protect his purchasing power, he might also need growth. And, as you might expect, this is where growth & income funds come in very handy. But, any blue chip stock that pays regular dividends would fit that bill, also. Or, even a bond that is convertible—that would be income plus potential growth. This test—you’ll see—likes to make you think way outside the box. Some firms separate growth from aggressive growth.  Aggressive growth investments include international funds, sector funds (healthcare, telecommunications, financial services, etc.) and emerging market funds (China, India, Brazil, etc.). For speculation, there are options and futures, and most investors should limit their exposure to these derivatives to maybe 5-15% of their portfolio.Some folks are already rich, and they wisely just want to preserve their capital (capital preservation). We won’t tell them about buying US Treasury securities all on their own, without commissions. Instead, we’ll put them into a US Treasury mutual fund. Even though the fund is not guaranteed, the securities the fund owns are.Need Help Passing the 7?

Suitability of Annuities on Series 7 Exam

If you're trying to make a recommendation concerning annuities in a Series 7 exam question, carefully read the facts to determine the following. First, does this investor want a safe, guaranteed rate of return backed by an insurance company's claims paying ability, or do they seek purchasing power protection/growth? If the former--they need a fixed or indexed annuity. If the latter, they're leaning toward a variable annuity--IF they can handle the risks of the stock and bond markets.

Now, when do they need the money to start coming out of the account? If they're at retirement age now, they need the money immediately--they want an immediate fixed, immediate indexed, or immediate variable annuity. If retirement is a long way off, and they won't have to touch this money for 10 years or more--they want a deferred fixed, deferred indexed, or deferred variable annuity.

Those are really the only big considerations. Do you want an insurance product or a securities product? Fixed and indexed annuities are insurance products. They buy a lot of sleep but don't provide much return. Variable annuities offer more upside and purchasing power protection, but the money is not really safe here. Then, when do you want to start taking withdrawals? Now--immediate annuity. Later--deferred annuity. Suitability Questions in ExamCram Online

Suitability and the Series 7 Exam

Hmmmmmmmm. . . . 

Registered representatives primarily make suitable recommendations to clients based on all kinds of factors: age, objectives, risk-tolerance, time horizon, personal values, tax situation, existence of retirement accounts, etc. So, rather than hitting you with a massive number of municipal securities and options questions, your exam is now expected to focus much more on suitability of customer recommendations. If your client has a son who is so far a so-so student, what if she wants to fund his education with a tax-deferred account, making sure he only gets the money if he actually goes to a 4-year college--which vehicle should she use: mutual fund, Coverdell Education Savings Account, 529 Plan, or UTMA? That is the kind of question (529 Plan, btw) you will likely see on the exam now. Has nothing to do with securities or economic factors at all--just asks you what are the features of these vehicles/accounts. You will also be expected to recommend various mutual fund options within a 529 Plan. When the child is very young, most people will invest in equity funds.When the child is 10 or so, probably time for a balanced fund. At age 16, with college a few years off, maybe 40% balanced fund, 40% short-term bonds, and 20% money market. Once college commences, maybe it's 50% short-term bonds and 50% money market.Notice how none of this is scientific, nor could it be verified by any particular document. If there were industry standards for suitability, we would find that all Target Retirement Funds have the same allocations and re-balance them at the same time. Nothing could be further from the truth.
What are you supposed to do, then? I recommend doing the quiz in Pass the 7 ExamCram called "Suitability of Customer Recommendations." Also, bone up on these topics from whatever textbook or questions you have: taxation, annuities, retirement plans, investment companies, economic factors. Get Pass the 7 ExamCram Online Test Prep

Closed-End Funds

As usual, I'm visiting the FINRA website on a Friday morning looking for recent regulatory actions. This morning I see an action against a couple of large firms concerning the fact that an IPO for a closed-end fund has a built-in sales charge (like any IPO) and, therefore, customers should not be advised to buy them during the offering and then dump them in the short-term. If you click on the link below you'll see how FINRA deals with such matters--they fine people, put them in the penalty box, and name names and reveal CRD numbers. In other words, it's a good idea to stay out of trouble. Check out the disciplinary action below. Once again you'll see how "real world" this Series 7 information actually is:

http://www.finra.org/Newsroom/NewsReleases/2009/P119457