How appropriate an investment is for you is a consideration at the very heart of the investment process. It is a fundamental concept both, from a legal perspective and in terms of putting an investor’s money to work sensibly and prudently.
When you, through an advisor or broker, invest your money in securities that aren’t suitable for your investor profile, there is a potential for unacceptable losses or very low returns. This can cause considerable distress for an investor.
FINRA Rule 2111 governs the obligations of advisors and brokers to ensure that investments are suitable for their clients.
Read on for a look at the concept of suitability and an advisor’s or broker’s role in helping their clients understand the risks and proper choices of investments and investment strategies.
Key Takeaways
- The suitability of an investment goes beyond a client’s assent to a transaction.
- An investment that does not fit the investment objectives and financial means of an investor is unsuitable.
- FINRA Rule 2111 address the obligations brokers have to ensure suitable investments for clients.
- A broker who fails to understand clearly a particular investment and a customer’s investment profile violates Rule 2111.
- Investors themselves should monitor their portfolios for suitable and unsuitable investments.
What Is Investment Suitability?
A suitable investment is defined by FINRA as one that fits the level of risk that an investor is willing and able, as measured by personal financial circumstances, to take on.
These criteria must be met. It is not enough to state that an investor has a risk-friendly investment profile. In addition, they must be in a financial position to take certain chances with their money. It is also necessary for them to understand the nature of the risks and the possible consequences.
Concern for Risk Profile and Asset Allocation
Risk
Why is suitability such an issue? It’s because investors often don’t understand what risk entails, and brokers can be tempted to advise people to make risky investments.
Further complicating the matter is the fact that excessively low-risk investments can be just as damaging to an investor’s portfolio as those that carry unsuitable levels of risk.
Therefore, suitability demands investments that are neither too risk-friendly nor too risk-averse for a particular investor.
According to FINRA regulations, a broker must have a reasonable basis for believing that an investment meets a client’s needs and objectives.
Asset Allocation
Unfortunately, suitability is not always entirely clear cut. While there can be no doubt that even a risk-friendly investor should not put 100% of their total assets into the stock market, when the percentage drops to, say, 60% or lower, the issue becomes less clear. But the allocation of assets remains key to being properly invested.
An investor who owns some real estate and has a conservative pension plan has different asset allocation needs compared to someone with a broadly diversified portfolio. Advisors and brokers must consider age and other aspects of the client’s personal and financial profiles, as well.
For example, it is unlikely that someone on the brink of retirement should have their entire account tied up in the futures market. However, the same person may be able to have 50% of their portfolio in conventional equities.
Bear in mind that this may be too risky for someone about to retire, at which time a portfolio of about 25% equities is generally considered more suitable.
Suitability largely boils down to asset allocation. Both the law and good investment practices prohibit anybody being prodded into an asset allocation that does not make sense.
An investor’s portfolio must be appropriately diversified so as to generate a reasonable level of returns at a reasonable level of risk.
Important
Determining whether or not an investment transaction or strategy is suitable for an investor is directly connected to investor protection and the ethical dealings of investment professionals.
Life Events Affect Suitability
Suitability is constantly in flux. As indicated above, what is suitable for someone who is 30 years old is very different from what that person will need when they are 60.
Getting married, having children, getting a big raise, or losing a job altogether should prompt a reconsideration of suitability.
As usual, this boils down to risk, asset allocation, and liquidity. If someone needs their money soon, tying it up in stocks doesn’t make sense. On the other hand, those who have many years to invest may want a portfolio that has a predominance of stocks for the purpose of growth and a lower percentage of government bonds.
Investors Must Understand Risks, Too
For investors themselves, an understanding of securities and risk also plays a role in suitability. But just because an investor understands the risks associated with, say, futures contracts, doesn’t necessarily make this investment suitable for them.
And if an investor doesn’t understand a complicated investment vehicle, such as a structured product, a straightforward mutual fund, may be more suitable.
For a broker, unsuitability can involve urging an investor to buy an asset that they are unfamiliar with. This can be viewed as an abuse of the investor’s knowledge of particular investments or investing overall.
And, if there are perfectly good alternatives with which an investor is more familiar and comfortable, there is no reason to take on more sophisticated instruments.
Note
Advisors and brokers must clearly understand how an investment works as well as the investment profile of a client in order to determine whether the two match up appropriately.
Unsuitable Investments and the Law
What does the law have to say about unsuitable investments? If an investor buys an investment purely on their own initiative (known as execution-only) and no one has advised the person to do so, there isn’t much the law can do.
On the other hand, if a broker or other financial institution advises an investor to buy an unsuitable investment, that financial professional could be liable for the investor’s losses, provided the person can prove the investment was unsuitable and that the broker or advisor did not make the risks clear.
As a result, in some cases, cautious brokers will only sell really high-risk and potentially unsuitable investments if buyers sign a document stating that they are aware of the risks associated with these investments.
Of course, firms generally have litigation insurance, so they can afford to fight claims of unsuitability in court. However, if investors can produce clear documentation of risk aversion and that an obviously high-risk investment cost them dearly, they do stand a chance in court.
But for investors, litigation remains a rocky road, which is often as costly as the unsuitable investments themselves.
What Can I Do if I Decided To Invest in a Security That’s Too Risky?
If you decided on your own to invest in it, without the advice of an investment professional, you can sell it immediately or keep it. If you sell and happen to make a profit on the transaction, don’t take that as a sign that the investment was right for you after all.
What if I Suspect That My Broker Is Buying Unsuitable Investments for My Account?
You can bring your concern to your broker and the firm’s management. A discussion might shed light on the reason for the purchases. If it makes you more sure that certain purchases were unsuitable, you can push for an appropriate resolution with management. You might also consult with a securities lawyer to see if a legal resolution should and can be pursued.
Are Investors the Reason for FINRA’s Suitability Rule?
The protection of investors and fair dealings for them are part of the reason. But Rule 2111 applies directly only to investment firms and the individuals associated with them.
The Bottom Line
No one should ever own investments that are not appropriate for their personal circumstances and their willingness to take financial risks.
At the extreme, truly unsuitable investments can destroy the value of a portfolio, but even lesser cases can cause undue stress for investors. Nothing in the investment process is more important than understanding the consequences of risk and allocating assets correctly.
Furthermore, investment suitability needs to be monitored regularly by investors and advisors.