Chapter 7: Suitability and Investment Risks
Before any recommendations can be made in communications, FINRA members must conduct a due diligence investigation on the product recommended. This process is called
Reasonable basis suitability Explanation: Reasonable basis suitability is required on a security or product before any specific recommendations can be made. The broker-dealer determines that there is reasonable basis to believe the security/product is suitable for any customer. The process must be documented.
Broker dealers and their representatives are held to suitability standards that apply to virtually all securities
Recommendations Explanation: It is the recommendation to buy, sell, exchange or hold securities that triggers suitability rules. When clients direct reps to complete a transaction (without a recommendation), suitability rules may not apply.
An investor with a relatively high-risk tolerance would like to add a growth fund to his portfolio. Of the following, which type of fund may be most appropriate?
Small cap stock fund Explanation: a stock fund is most appropriate for a growth objective. Because this investor is not risk averse, a small cap fund will offer the most growth potential of the choices offered.
Total Return on Equity
The total return on a stock investment is calculated (as dividends plus capital gains) divided by the initial purchase price of the shares.
Jane purchased ABC stock for $100 and sold it one year later for $110. She also received $5 in dividends. What is the total return?
Total return = ($5 dividend + $10 capital gain)/$100 purchase price = 15%
An investor in a high tax bracket is subject to federal, state and local income taxes. If the investor is seeking current income with minimum tax liability, which of the following choices is most appropriate?
U.S. Virgin Island Utility bonds Explanation: bonds issued by U.S. Virgin Islands and other U.S. territories and possessions are exempt from federal, state, and local taxes. Double-barreled bonds, like other municipal bonds, are exempt from federal and possibly state taxes. Private activity bonds may be subject to alternative minimum taxes. Treasury STRIPS are subject to federal income tax, and do not provide current income.
Institutional Threshold
Under FINRA suitability rules, an individual with assets of at least $50 million is considered an institutional investor
Investors who indicate they are seeking current income from an investment would be least likely to consider which of the following products?
Zero-coupon bonds Explanation: zero-coupon bonds do not generate any current income so they would not be appropriate investments for someone whose investment objective is current income.
The overall objective of asset allocation is to ensure that investors have
a blended portfolio of assets that will react differently under different market conditions Explanation: the objective of asset allocation is to ensure that the portfolio includes asset categories that react differently under diverse market conditions
An investor can avoid reinvestment rate risk by purchasing
a zero-coupon bond Explanation: reinvestment rate risk can be avoided when an investor purchases a zero-coupon bond
According to the customer-specific suitability standards, a broker must determine that a recommendation is
always suitable for that customer Explanation: A broker must have a reasonable to believe, based on specific information known about the customer, that a recommendation is suitable for the customer
The risk that a technology or product will become obsolete, causing the company to discontinue operations is
business risk Explanation: Business risk is the risk that a company will no longer continue operations, typically due to an outdated technology or product preference.
An institutional portfolio includes commercial paper, variable-rate demand obligations, and in-state AAA municipal bonds. The investment objective of the portfolio could include all of the following EXCEPT
capital appreciation Explanation: the securities in this portfolio offer safety of principal, tax exempt income and liquidity. Growth, capital appreciation, and speculation are objectives that are not achieved with this portfolio.
When growth is the primary investment objective, an investor's portfolio would likely be focused on
common stock Explanation: where growth is the primary investment objective, there would be a focus on equity securities, particularly common stock, which over the course of many years will tend to increase in value
An investment denominated in a foreign currency may lose value or depreciate as the US dollar strengthens. This is an example of
currency risk Explanation: This is the essence of currency risk. As one currency risk weakens, another currency will strengthen
To ensure that a suitable recommendations are made to customers, broker-dealers are required to make reasonable efforts to obtain all of the following types of customer information EXCEPT:
educational background Explanation: the suitability rule focuses on whether such specific recommendation is suitable for the client's financial and tax status, as well as the client's investment objectives. It does not require a broker-dealer to inquire about a client's educational background
An 80-year-old institutional would be least likely to purchase a
hedge fund Explanation: an individual who is retired, or in the later stages of life, would not be likely to make an investment that could result in the complete loss of their capital, or one that would require a long-term investment horizon
Individuals seeking tax-free income are likely in
high tax brackets
Which of the following investment products would not be appropriate for an individual who says her current investment objective is growth?
high-grade municipal bond Explanation: growth oriented investors would be interested in equities and equity municipal funds. Fixed-income products would not be a suitable investment for this investment objective.
The risk that stock cannot be sold easily or promptly is known as
marketability risk Explanation: the risk that a security cannot be easily converted to cash is known as marketability or liquidity risk
Political risk may be mitigated when an investor focuses attention
on US domestic securities Explanation: political risk can be reduced by investing in US domestic securities in lieu of overseas investments
The stock of a company with no earnings history, but high potential for appreciation is most likely classified as a(n)
speculative stock Explanation: speculative stocks generally have no earnings history, or widely varying earnings, but they have high potential for appreciation because of their future promise
One important component of an investor profile is called risk tolerance. What is the best definition of this term?
A customer's willingness to risk losing part or all of an investment in exchange for higher potential return Explanation: Risk tolerance measures a customer's willingness to risk losing part or all of an investment in exchange for higher potential returns. It is, admittedly, a subjective measure. However, the process of evaluating risk tolerance often forces customers to consider how much loss they would be willing to sustain.
Liquidity Risk
A security that cannot easily be sold is said to have liquidity risk. Examples of illiquid investment include direct participation programs and thinly traded stocks, such as penny stocks.
When recommending a specific municipal bond to a client, which of the following factors is least relevant in making a suitability determination?
Ages of their children. Explanation: the age of a client's children would be the least significant factor of the options provided
Safety and Preservation of Capital
An investment objective in which an investor seeks no decline in the value of their investments. Suitable investments for this strategy would include highly rated instruments such as Treasury and money market securities. Investments where there is a risk of loss of principal, such as common stock, penny stocks, direct participation programs, and high-yield bonds, are inappropriate.
Current Yield of Common Stock
Another way to evaluate the return on common stock is by calculating its current yield, which is the annual dividend divided by the current market price. Make sure that if the quarterly dividend is provided that you annualize it by multiplying by four.
XYZ Stock is trading at $15 and pays a quarterly dividend of $0.30. What is the current yield?
Current Yield = ($0.30 x 4)/$15 = 8%
What are the two components of total return in common stock?
Dividend income and price change Explanation: Total return is the average annual positive or negative return for a buy-and-hold equity investor, assuming dividends are compounded. The calculation of total return is dividend income plus any price gain (or, if the stock declined in value, minus any price loss)
Which of the following securities is the least liquid?
Hedge funds Explanation: a hedge fund is not a liquid product. It usually requires a significant investment of capital, and a long-term investment horizon
Fund Investing
If the manager of a fund believes there might be a short-term drop in the market, they could keep the excess cash in cash and cash equivalents then buy the dip.
A closed-end fund investor that is most concerned with issuer risk in an income portfolio should feel most comfortable with which of the following funds?
Investment grade corporate bond fund Explanation: of these choices, the investment grade corporate bond fund is most focused on maintaining a portfolio of highly rated bonds that reduce issuer risk. An investment grade rating means that outside agencies have reviewed the issuer's strength and have identified a low risk of default
Which of the following is a significant risk of a raw land limited partnership program that must be disclosed by a registered representative?
Lack of liquidity Explanation: a raw land partnership has high appreciation potential. it does not pass through losses because there are no expenses associated with development of the land or depreciation. The lack of liquidity is a risk that must be disclosed.
Preferred Stock Investment Objective
Preferred stock pays a fix quarterly dividend and is therefore appropriate for an investor seeking current income. However, because of the fixed dividend, preferred stock does not have as much potential for appreciation and capital gains. For an investor seeking growth, common stock would be more suitable.
