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CUSTOMER SUITABILITY AND MAKING THE RIGHT RECOMMENDATIONS

So we’ve covered the different account options and from time to time spoken about determining suitability when it comes to the type of securities and products a customer should be investing in.

That’s something that we are going to look into a little more now.

The Series 6 exam, in particular, does focus more on making the right recommendation when it comes to investment products over how these investment products actually work.

When you see these types of questions on the exam, they are mostly focusing on retail customers.

To start the suitability process, a registered representative must consider a customer’s circumstances and distinguish between financial and nonfinancial information.

Foundation is key

Each customer is different, that goes without saying.

It’s important to check their base, or foundation before they start investing.

A solid base is certainly necessary and if there isn’t one, it should be improved before they buy their first security, that’s for sure.

So how do you go about that?

Well, there are a few things you can consider:

  • What are their insurance needs and do they have the necessary products in place to meet these needs?
  • If they are married and parents, one of the most important factors is life insurance
  • What’s their overall health like? Medical procedures are expensive and a health issue can hinder long-term plans
  • Is disability insurance something that the client has considered or has in place? Again, just like a health issue, a disability can affect a person’s ability to earn an income
  • Do they have any cash reserves in place? Usually being able to cover living expenses for between three to six months is considered to be enough cash reserves. Things like major car or home repairs, medical emergencies that fall outside of insurance cover, and the loss of employment are reasons why cash reserves are necessary.

What financial considerations are important?

A registered representative must find out information that pertains to each of their customers, both from a financial and non-financial point of view.

When it comes to financial considerations, the best way to determine these is by asking direct financial questions.

And, for the most part, the answers are something that will appear on the personal balance sheet or income statement of the customer.

An example of a question you might ask is something like: “How much do you earn before taxes per annum”.

Another question is, “What is the current worth of your Roth IRA?”

You need to ask direct questions to get the information you need to paint a picture of where your new client is in a financial sense.

Another important aspect that can provide you with the answers from a financial standpoint is the balance sheet of each customer.

It provides the registered representative with a view of the customer’s financial condition at that specific point.

Use it to calculate their net worth (take their assets and subtract their liabilities and you have your answer).

These are the types of questions that a registered representative should ask to help determine a customer’s status when it comes to their personal balance sheet:

  • Can you tell me what are the physical assets that you own? With this question, you need to nail down all the assets an individual has. This will include their home, their car, if they have any collectibles (for example, jewelry, art, or other valuables), or other property.
  • Do you have any liabilities? This would include home mortgage payments, payments on a vehicle, any loan payments, or other financial commitments that they have to pay regularly, for example, child support.
  • Do you have any current investments? This can help you find out if the customer already has any securities that they have invested in, for example.
  • Do you have an investment account that has been established with the long-term in mind? This can help you to find out if the customer has thought about long-term planning for their retirement, for example. Ask them if they have an IRA, a profit-sharing plan, or a corporate pension. Or perhaps they are already contributing to annuities. You can also find out if they have any life insurance products using this line of long-term planning questioning.
  • Do you know what your net worth is?
  • How much of your net worth is liquid? This helps to determine how much cash on hand a customer has.

I am sure that you can see just how these questions will help in determining the overall financial circumstances of each customer.

It can give you an idea as well into their history of investing (if any).

It’s the perfect way to get the information you need that will start to paint a clearer picture of their financial situation and what you will be working with.

Once you’ve completed a customer’s balance sheet, you can then move on to the next step and that’s working on their individual income statement.

Without knowing the situation around a customer’s financial background with regards to income, it’s not going to be possible to make investment recommendations that are appropriate to them.

Again, to do this, simply ask the right questions.

This will help find out clues as to what changes might occur in their future or what responsibilities they have financially.

Here are the types of questions that you would ask in this section:

  • Can you tell me what your overall gross income is?
  • Do you know what your overall family income is (for example, what both the customer and spouse earn)?
  • Is your income stable?
  • Over the next few years, will there be any major changes that will affect this income?
  • After expenses, what is your spendable income?
  • Of that spendable income, how much can you make available towards investments?

The benefit of these types of questions is that they will provide the registered representative with information as to what a customer’s current priorities might be.

It also provides an overview of their current cash flow.

Again, it’s about building the overall financial picture for each client and from that, working out the best possible way to help them invest.

What nonfinancial considerations are key?

When a registered representative has all the financial information they need from a client, the next step is to start looking into the nonfinancial information that’s critical too.

In a nutshell, if you cannot express some form of the necessary information as a numerical value, be it a cash flow or a sum of money, for example, the information is considered nonfinancial.

This doesn’t make it any less important, however.

Here’s the type of information a registered representative will need from their customers:

  • The individual’s age
  • Their marital status
  • If they have any dependants and if they do, their ages
  • If they are employed
  • Where they are employed
  • If their family members are employed
  • Educational needs of their family now
  • Educational needs of their family in the future
  • Health care of their family currently
  • Health care needs of their family in the future
  • Their overall tolerance to risk
  • Their overall attitude towards investing
  • Their current tax status

This is just the most important nonfinancial information that you will need, but it might not be all of it.

There’s more you can come up with based on the individual you are dealing with.

What’s critical is to try to best understand how each individual will look at investments and their overall aptitude for them.

Try to find out from each customer:

  • When it comes to investment risk, how far are they able to go?
  • What kind of liquidity do they expect from their investments?
  • Will tax considerations play a role in their investments?
  • What is the time frame for their investments? Are they looking for long-term or short-term?
  • Do they have any experience when it comes to investing?
  • Are they currently holding any investments?
  • Should the principal they’ve invested lose money, how would they react? Make sure you give them scenarios, for example, if they lost 10% of their principal or 50%. Their reactions to that might be very different.
  • What level of return on their investment are they looking for?
  • Would stable investments with less risk become boring for them?
  • Overall, will market fluctuations bother them?

All of this information will ultimately help a registered representative to provide their customers with suitable recommendations at the end of the day.

Customer recommendations: Applying suitability standards

When a registered representative gets to the point that they are going to suggest investment products to a customer, it’s always done with suitability standards in mind.

Let’s look at those that should be considered.

To start, there are the overall investment objectives of the customer.

In determining the reasons why a customer wants to invest, you’ll come across many different reasons.

For the most part, people want to see their invested money make them more money, that just stands to reason, right?

But you cannot just choose the first investment product you can think of that might do that.

By asking the right questions, a registered representative will work out which growth investment will be perfect for a customer and which wouldn’t be based on their income, tax status, and whatever else you have learned about them.

Here are some of the more common financial objectives that customers might want to reach through investment.

First, we have capital preservation.

This is a pretty big deal for many investors.

They have capital and they want to use their investments to help preserve that.

If a client emphasizes that investment should be safe, then certainly they are wanting to preserve their capital and not take risky investments that, while they might mean more money, could lead to a loss of principal as well.

The best types of investment products that meet suitability standards for an investor with capital preservation in mind are CDs, U.S. government treasuries, and money market mutual funds.

If the customer is looking to invest for a long period of time, a principal-protected fund might also be an option.

Next, there is current income.

Investors with fixed income often turn to the world of investment as a way to generate more current income.

That can be achieved by investing in securities that generate proceeds for those that invest in them.

A good example of this is various types of debt securities.

These include agency securities, municipal bonds, government bonds, corporate bonds, and others that will provide regular interest income.

Other securities that could fall under this category are those that produce dividends, like equity investments.

These include blue-chip stocks or preferred stocks that have a history of providing an income stream for those who invest in them.

Income-oriented mutual funds and other pooled investments are another option to help generate current income.

Municipal bonds might be an option for customers that are in higher tax brackets.

That’s thanks to the fact that interest received on them is not taxed federally.

The next financial objective a customer might have is capital appreciation or growth.

When a customer wants their investment to increase in value over the period of the investment, this is known as capital growth.

Generally, this will happen when the value of the securities that have been invested in goes up.

Generally, the best way to ensure capital growth is by investing in equity-oriented investments.

Should an investor be retiring in 10 years, or perhaps is investing towards helping to fund their children’s college education, suggesting a capital grown investment is appropriate.

Some investors might be looking for the tax advantages that certain investment brings.

Investments can be a tool for people to help lower their taxes.

For example, interest will accumulate on products such as annuities and IRAs.

This interest is tax-deferred and it’s only when the money is taken out of the account that taxes are then paid on it.

Better still, some investments will provide a customer with income that’s tax-free.

Municipal bonds are an excellent example of this.

Portfolio diversification is often another common financial objective for investors.

Without a doubt, an investor who invests all their money in just one type of security is risking more than those that will diversify their portfolios.

There are so many excellent options when it comes to diversifying an investor’s portfolio.

For example, just because of the way they are structured, mutual funds are a brilliant example of diversification.

Also, stocks, bonds, cash, and even real estate and hard assets form part of asset allocation funds.

Further diversification can be achieved by investing in global and international funds if a customer wants to move away from just looking at domestic options.

Next, we have liquidity.

Many investors are prepared to put money in an investment but not have access to it whenever they feel it necessary.

For these customers, the most suitable products are those that offer liquidity.

If the investor so chooses, they can sell these investments for a fair market price or at their face amount.

When it comes to liquidity, however, there is no guarantee in place that an investor might not lose some money but many investors are prepared to take that risk to gain the current market price should they wish to generate funds quickly.

Examples of liquid investments are products like exchange-listed securities, Nasdaq securities, and mutual funds.

Investments that don’t offer much liquidity include stock or bonds that are not Nasdaq listed, annuities when first bought, or those for investors that are younger than 59.5, real estate, and limited partnership units.

For the Series 6 exam, it’s important to remember that annuities are never considered a liquid investment.

That’s due to the fact that they have a surrender penalty.

The last thing we need to cover in this section is speculation.

When an investor is willing to take higher risks for higher rewards, that’s known as speculation.

The types of investments that would suit the suitability requirements for this type of investor include option contracts, special situation funds, precious metals, sector funds, high-yield bonds, and non-Nasdaq stocks or bonds.

Providing suitable recommendations to investors

The primary and secondary objectives of the investor should be the main areas that drive a registered representative’s recommendations to a customer.

Here’s how they can go about that.

To start, look to match their primary objectives first.

If you’ve followed the process described above and found out all the relevant information that you need about an investor, you should have recommendations that are the most important in meeting an investor’s primary objective.

Should the investment product that you want to suggest not meet an investor’s primary objective, it simply cannot be deemed to be suitable.

Don’t forget secondary objectives either.

They can help guide a registered representative, especially if a number of investment products meet the primary objective of the customer.

By looking at their secondary objectives, you can narrow down the options that you will present to them.

Most notably, things like liquidity or the overall risk tolerance of a customer will help guide you in this regard.

Then there is examining similar investments.

The Series 6 exam might have you analyze two similar investments and ask which is the most suitable for a customer.

The best way to do this is by comparing one against the other.

You can use various points of comparison including:

  • Long-term performance vs performance over the same period of time
  • Which investment includes a tax advantage (if any)?
  • Which investment is the more volatile option?
  • When comparing corporate investments, how do the financials of each company look?

Guidelines: Suitability recommendation

  • Preservation of capital/safe investments: money market funds, fixed annuities, corporate bond funds, investment-grade corporate bonds, agency issues, CDS, government securities/funds, and agency issues
  • Some growth: Common stock mutual funds and common stock
  • Moderate/balanced growth: defensive stocks and blue-chip stocks
  • Aggressive growth: sector funds and technology stocks
  • Income: REITs, CMOs, any bonds (not including zero coupon bonds)
  • Tax-free income: Roth AIRs, Municipal bonds, and municipal bond funds
  • High-yield income: Corporate bond funds and corporate bonds (below investment grade)
  • Income from stock portfolio: Blue-chip stocks, utility stocks, and preferred stocks
  • Liquidity: Nasdaq bonds and stocks, exchange-listed securities, REITs (that are traded publicly), mutual funds
  • Portfolio diversification: Asset allocation, balanced and other mutual funds, debt securities (for equity portfolios), foreign securities (for domestic portfolios, diversification via rating or region (for bond portfolios).
  • Speculation: Futures, commodities, precious metals, sector funds, unlisted or non-Nasdaq bonds or stocks, options contracts, high-yield bonds, DPPs
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