When you see suitability questions on the exam, you’ll often be given an investor’s investment objective. An investment objective describes the investor’s overall goal for their invested capital (money). Financial professionals use the objective to evaluate whether the investor’s current asset allocation is suitable and to decide what types of investments to recommend.
You’ll want to know each objective, what it implies about risk and time horizon, and how it guides suitable recommendations. The investment objectives covered here are:
Preservation of capital applies when an investor wants to invest while taking as little risk as possible. It’s the least risky objective and may involve insured products (like a certificate of deposit). Securities suitable for this objective are generally short-term debt securities with minimal risk exposure.
Investors most likely to choose preservation of capital include:
Specific investments suitable for a preservation of capital objective include:
Safety of principal is one step higher on the risk spectrum than preservation of capital. Investors with this objective often allocate heavily to safe debt securities with longer time horizons. Because long-term debt securities have more price volatility, this objective accepts a bit more market risk than preservation of capital.
In most cases, these investors want stable income over long periods of time. Older investors in retirement are the most likely to identify safety of principal as their overall investment objective.
Specific investments suitable for a safety of principal objective include:
An objective of tax-advantaged income fits investors who want income that is taxed at lower rates or is tax-free. This is most common for investors in high tax brackets or organizations with significant tax liabilities.
This objective isn’t limited to short- or long-term investing, although recommendations often lean toward longer-term fixed-income securities to pursue higher rates of return.
In general, there are two primary investment products that provide tax-advantaged income:
*While dividends from stock are taxed at lower rates (15% or 20%) than interest from bonds (up to 37%), preferred stocks are especially suitable for corporate investors. Corporations are able to deduct at least 50% of the dividends they receive from taxation.
An investor with a moderate income objective wants income and is willing to accept some risk to earn more than the lowest-risk choices typically provide. The typical investor is older, but not in a situation where they must be completely risk-averse.
For example, a 60-year-old recent retiree with a funded retirement plan may want to replace employment income with fixed-income securities that aren’t extremely safe but also aren’t highly risky.
Specific investments suitable for a moderate income objective include:
Investing in common stock typically involves at least a moderate level of risk. Investors seeking capital appreciation (buy low, sell high) through common stocks - without taking on extreme risk - often have a moderate growth objective (sometimes called simply “growth”).
Younger-to-middle-age investors with long time horizons and no need for current income are the most likely to have a moderate growth objective.
Specific investments suitable for a moderate growth objective include:
An investor with a high-yield income objective is willing to take significant risk to earn higher yields from fixed-income securities. These investors often buy junk bonds, which are rated BB or below by the rating agencies. In many cases, the issuers are legitimately at risk of bankruptcy.
Junk bonds typically have two characteristics that contribute to high yields:
Preferred stock - especially from distressed issuers - may also be suitable for this objective. Like junk bonds, this type of preferred stock tends to offer higher dividend rates while trading at discounts.
Investors seeking high-yield income are typically aggressive investors looking for higher returns from fixed-income securities. Elderly and conservative investors usually avoid this objective because of the risks involved.
Specific investments suitable for a high-yield income objective include:
Growth (capital appreciation) involves buying securities at a lower price and selling later at a higher price. We’ve already covered growth-focused companies, which aim to increase revenues through expanded operations.
An aggressive growth objective focuses on higher-risk investments with higher potential returns, often in smaller companies. For example, if you invested in Amazon during its IPO in 1997 when it was an online bookstore, its IPO price was $18 per share, and Amazon later traded above $3,000 a share (as of September 2020). That’s a return of over 16,000%. Amazon’s business model was largely unproven in the late 1990s, but it eventually became one of the largest companies in the world.
For every Amazon, there are many companies that never become successful. In fact, only a third of small businesses survive their first 10 years of business. Survival doesn’t necessarily mean profitability, and it often takes years before small businesses and start-ups become profitable.
In addition to small businesses, companies from emerging markets can also offer high growth potential. Emerging markets are regions that historically haven’t been major players in the world economy but are becoming more prominent. Mexico, Thailand, and South Africa are examples. As these economies grow, companies in those regions may grow as well.
Investors in emerging market securities also face risks beyond typical business and financial risks. Many regions have governmental issues (corruption, “red tape,” etc.), economic problems, and weak infrastructure for business.
Certain sector funds are also suitable for aggressive growth. Sector funds invest primarily in stocks of companies from a specific industry. Technology and energy tend to be among the more aggressive sectors, offering higher risk and return potential.
An investor with an aggressive growth objective accepts that many investments may fail, but expects the winners to outperform the losers. These investments tend to have high betas, meaning their market prices historically have moved faster than the general market.
This objective is only suitable for investors who are very comfortable with risk. Time horizons can be long or short, although it’s generally more prudent to use a long time horizon with risky strategies. A longer time horizon gives the investor more time to recoup losses if an investment drops significantly. These investors also tend to be young and not focused on current income (growth companies generally don’t pay dividends).
Specific investments suitable for an aggressive growth objective include:
Speculation involves investing, but it can resemble gambling because it often depends on short-term market direction, which is highly unpredictable. Speculative investors typically take positions based on short-term price movements.
If the “bet” is right, the investor may make significant money quickly. If the “bet” is wrong, it’s possible to lose more than the account is worth.
Speculation is the riskiest investment objective and is only suitable for the most aggressive investors. Younger investors with significant assets are the typical investors for this objective.
Specific investments suitable for a speculation objective include:
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