Suitability refers to the risks and benefits of an investment. It helps you decide whether a particular investment is appropriate for a specific investor. The Series 6 exam includes many suitability-based questions.
As we cover different investments, you’ll want to understand the BRTI of each product:
If you can clearly identify these three elements for each investment product, you’ll be able to make consistent suitability decisions on the exam and in practice.
In this section, we’ll look at the BRTI of common stock.
Common stock is typically associated with three main benefits:
Capital appreciation (also called growth or a capital gain) occurs when an investment’s value rises above its original purchase price. For example, if you buy a stock at $50 and sell it at $75, you have a $25 capital gain.
Because there’s no cap on how high a stock price can rise, common stock has unlimited gain potential. As the market rises, the investor’s potential gain rises as well. For many common stock investors, capital appreciation is the primary source of return.
A gain is unrealized until the investment is sold. Stock prices can fluctuate sharply in short periods. For example, during the early stages of COVID-19 in the United States, the S&P 500 fell 12.5% in March 2020 and then rose 12.6% in April 2020. For context, the S&P 500 averages around a 10% annual return. In other words, the market moved about a “typical year’s” amount in a single month.
The key point is this: you must sell the security to lock in the gain. Once the stock is sold, the gain becomes a realized gain. Until then, the investor is exposed to market swings.
Growth stocks are the most likely to provide capital appreciation. These are stocks of companies focused on increasing revenue, often at a faster rate than the overall economy. Many companies begin as growth companies while they expand operations and build market share. Companies like McDonald’s, Walmart, and Home Depot fit this description earlier in their histories, but today they’re large, mature businesses that are typically beyond their most rapid growth phase.
Some large, well-established companies are still considered growth companies. For example, Amazon is widely known and established, but it continues expanding into new industries. It reinvests profits by hiring large numbers of employees, acquiring other companies, and improving existing operations.
Amazon has never paid a cash dividend, which is common for growth companies. Cash dividends are corporate earnings distributed to shareholders. Growth companies often avoid dividends so they can reinvest earnings into expansion. If management believes reinvesting profits will create more value for shareholders than paying dividends, it will typically choose reinvestment.
The other way common stock can generate return is through income from cash dividends. While growth companies rarely pay dividends, larger and more established companies (often beyond their rapid growth phase) commonly do. McDonald’s, Walmart, and Home Depot all pay quarterly cash dividends.
Many large dividend-paying companies focus on maintaining or gradually increasing market share rather than pursuing major expansion. For example, Walmart already has a global presence and generates around $500 billion in annual revenue, which is why it’s often described as a blue chip company.
Because Walmart isn’t directing as much of its earnings toward aggressive expansion, it can distribute a meaningful portion of earnings to shareholders. One way to measure this is the dividend payout ratio, which compares dividends paid to earnings.
Here’s the dividend payout ratio formula:
Continuing with Walmart, here are its 2019 (fiscal year) figures:
What is Walmart’s dividend payout ratio?
Answer: 40.6%
Value companies are also known for paying cash dividends. If a stock is trading at a perceived “bargain,” it’s often described as a value stock. This is more common among larger, well-established companies. Value companies may offer dividends that are relatively large compared with the stock’s price.
Some investors build large dividend-paying stock positions and use the dividend income for living expenses. This can be especially appealing for retired investors who want portfolio income.
Dividends are not guaranteed, which matters for both risk and return. A company can reduce or eliminate dividend payments at any time. This often happens during economic downturns. For example, many companies reduced or ended dividends during the Great Recession of 2008 and throughout the COVID-19 crisis.
Common stock can also serve as a hedge against inflation. Inflation occurs when general prices across the economy rise, which reduces the purchasing power of the U.S. dollar. A simple way to recognize inflation is to compare what everyday items cost decades ago versus today.
Over long periods, the stock market has generally outpaced inflation. As the prices of goods and services rise, many companies can raise prices and grow revenues, which can support higher stock prices over time. That’s why stocks are often viewed as a place to keep money when you want some protection from rising prices.
Investment risks are often grouped into two broad categories: systematic and non-systematic. Systematic risk is risk that affects the overall market. We’ll cover non-systematic risks later in this chapter.
Market risk is a type of systematic risk. It occurs when an investment declines in value due to broad market or economic conditions.
The Great Recession of 2008 is a clear example. The S&P 500 (an index of 500 large domestically traded stocks) fell 38% in 2008. A decline of that size is a sign that most stocks are falling together.
Even strong companies can be hit by market risk. For example, Apple (AAPL) fell 56% in 2008, even though the first iPhone had been released the prior summer. If you invested $1,000 in Apple on January 1, 2008, you would have had $440 at the end of the year. The company’s business model wasn’t the issue - the broader economic environment was.
A key suitability point: diversification can’t eliminate market risk. When the overall market is falling, a diversified portfolio may still lose significant value.
We covered the basics of inflation risk (also called purchasing power risk) earlier in this chapter. Here’s the deeper idea: inflation means prices rise over time, so each dollar buys less.
For example, the median home price in 1950 was around $7,000, but rose to $120,000 50 years later in 2000. This reflects inflation, which tends to occur naturally over time at an average rate of 2-3% annually.
Inflation is commonly measured using the CPI (consumer price index). Each month, the U.S. Bureau of Labor Statistics tracks price changes of goods and services. When prices rise on average, CPI rises (and vice versa). On the Series 6 exam, CPI is essentially a reference to inflation.
Normal inflation (2-3% annually) is generally expected. Higher-than-expected inflation can create short-term problems for common stocks. When costs rise quickly (for example, in late 2021-2022), companies may struggle to maintain profit margins. Supplies become more expensive, businesses raise prices, and demand can fall. In the short term, this can push stock prices down.
Over the long term, the stock market has tended to outpace inflation. Inflation spikes have historically been temporary, and the Federal Reserve may take action to prevent inflation from rising too far. The last major inflation period in the U.S. before late 2021/2022 was in the 1980s. Eventually, prices stabilized and the economy recovered.
For the exam, focus on these two major systematic risks:
Non-systematic risk affects a specific company, investment, or sector rather than the entire market.
A company faces financial risk when it runs into financial trouble, often because it’s over-leveraged (it borrowed too much money). Tesla (TSLA), for example, faced financial risk for many years. Even if demand for a company’s product is strong, heavy debt obligations can create serious problems. When financial risk increases, stock prices often decline.
Business risk is related but different. Instead of debt being the main issue, business risk occurs when a company struggles with its core business - often due to competition, poor management, or changing consumer preferences.
Radio Shack is a classic example. The company peaked in 1999, then lost customers and revenue to competitors like Best Buy and Amazon while failing to adapt to changes in technology and retail. Eventually, Radio Shack filed for Chapter 11 bankruptcy in 2015, and again in 2017 after restructuring. Business risk can drive a company’s stock price down.
Regulatory risk occurs when a company faces challenges due to current or potential government regulation.
For example, when Mark Zuckerberg (CEO of Meta (Facebook)) was asked to testify to Congress regarding privacy concerns, Meta faced regulatory risk. If lawmakers impose new rules, the company may need to spend significant money updating policies, training, and business practices. Even if regulation benefits society, it can reduce profitability and push the stock price down.
Many common stocks trade on exchanges, such as the New York Stock Exchange. You’ll learn more about the stock market later in this material. For now, assume that exchange-traded stocks generally have active trading and are relatively easy to buy and sell.
Not all publicly traded stocks trade on exchanges. Many smaller or start-up companies trade in the OTC markets. These stocks often have lower trading volume than exchange-listed stocks. As a result, it may be harder to sell an OTC stock quickly.
When an investor has difficulty converting a stock into cash, they face liquidity risk (also called marketability risk). To sell a security with limited demand, an investor may have to accept a much lower price.
Here’s a video breakdown of a practice question on non-systematic risks:
In summary, these non-systematic risks affect specific companies, investments, or sectors. Unlike systematic risks, non-systematic risks can be reduced through diversification. The more investments an investor owns, the less the portfolio depends on the performance of any single holding.
When an investor lacks diversification, they face concentration risk, which amplifies the non-systematic risks discussed above. For example, financial risk becomes much more significant if an investor owns only one company with high debt levels. The risk is concentrated, so the impact is larger.
For the exam, you’ll need to know:
In general, common stock investing tends to fit investors with:
Stocks can experience large price swings. Investors who can’t afford (financially or practically) to handle significant fluctuations in account value may need to limit stock exposure.
Older investors can still hold common stock, and many should. However, the stock allocation often declines with age because older investors are more likely to:
A common guideline is the rule of 100. Under this rule, you subtract your age from 100 to estimate the percentage of your portfolio that might be allocated to stock. For example:
| Age | Stock % | Bond % |
|---|---|---|
| 30 | 70% | 30% |
| 45 | 55% | 45% |
| 60 | 40% | 60% |
| 70 | 30% | 70% |
This guideline reflects a basic idea: as investors age, they often shift more money toward fixed-income securities like bonds.
Age isn’t the only suitability factor, but the rule of 100 is a useful starting point. Other factors can change what’s appropriate. For example:
Time horizon is another major factor. In the short term, the stock market can be unpredictable. COVID-19 is a good example: in late 2019 and early 2020, the market was near all-time highs, then experienced the fastest market decline in history in March 2020. Short-term market direction is difficult to predict.
Over long periods, investors often expect the market to rise. Over the past 100 years, there have been many bear markets and major declines, including the Market Crash of 1929 (which contributed to the Great Depression) and the Great Recession of 2008. Despite severe declines, the market eventually recovered and moved beyond prior highs. The COVID-19 stock market recovery was relatively quick, with the S&P 500 reaching a new all time high in September 2020, less than six months after the fastest decline in history. Recoveries can take months or years, but historically they have occurred.
The typical common stock investor may be seeking:
Some stocks primarily offer capital gain potential (often smaller growth companies or large companies aggressively expanding). Amazon is a good example.
Other stocks may offer a combination of dividends and more modest growth. Companies like McDonald’s, Walmart, and Home Depot pay quarterly dividends, and their stock prices may still rise over time (though often with less growth potential than a pure growth company).
Sign up for free to take 22 quiz questions on this topic