Sidenote
The suitability chapter
One of the most important test topics on the Series 6 is making suitable recommendations. We’ve covered product risks, benefits, and typical investors extensively through previous product-focused chapters. Additionally, we discussed the ethics of operating as a registered representative and market dynamics to be aware of. The aim of this chapter is to provide a “boost” to your suitability skills by reviewing these older topics, while introducing some new concepts and test-taking skills.
Try to approach these sections with a holistic, “big picture” approach. You’ll likely encounter numerous scenario-based suitability questions on the exam that require your knowledge of securities and careful consideration of the client’s needs and goals. While these questions are difficult, they can be answered correctly on a consistent basis when integrating the lessons learned in this chapter.
This summary section provides the most important test points related to the various products we’ve discussed. As always, keeping track of each product’s “BRTI” (benefits, risks, and typical investor) is essential to consistently answering suitability questions correctly.
Common stock
Benefits
Capital appreciation potential
Dividend income potential
Systematic risks
Market risk
Inflation risk (short term only)
Non-systematic risks
Business risk
Financial risk
Regulatory risk
Liquidity risk (for unlisted securities)
Typical investor
Seeks capital appreciation and/or dividend income
Younger
Risk tolerant (moderate to aggressive)
Long-term time horizon
Resources : ‘What is common stock?’ video
Preferred stock
Benefits
Dividend income
Capital appreciation if convertible
Risks
Dividends not guaranteed
Interest rate risk
Inflation risk
Call risk
Reinvestment risk
Typical investor
Seeks income
Accepts moderate risk in return for higher income
Corporate investors (dividend tax exclusion)
Long-term time horizon
General debt securities
Benefits
Interest income, which is legally guaranteed
Risks
Interest rate risk
Inflation risk
Default risk
Liquidity risk
Legislative risk
Political risk (foreign debt securities)
Reinvestment risk
Call risk
Typical investor
Seeks income
Generally older
Risk averse (conservative)
Corporate debt
Benefits
Interest income
Capital gain potential for convertible bonds
Higher yields (vs. other debt issuers) due to risk
Variety of choices and risk profiles
Risks
Interest rate risk
Inflation risk
Default risk
Liquidity risk
Legislative risk
Political risk
Reinvestment risk
Call risk
Typical investor
Seeks income
Generally older
Willing to take higher risk (vs. other debt issuers)
Certificates of deposit
Benefits
Interest income
FDIC insurance up to $250,000 per bank
Risks
Low yields in exchange for safety
Interest rate risk (particularly for long-term brokered CDs)
Typical investor
Willing to accept low yields in exchange for safety
Typically older or elderly
Municipal debt
Benefits
Tax-free interest income for residents
Typically safe securities
Risks
Low yields (opportunity cost)
Interest rate risk
Inflation risk
Some default risk (although low)
High liquidity risk
Reinvestment risk
Call risk
Typical investor
Seeks income
High income / wealthy (high tax bracket)
Willing to accept lower yields in exchange for tax benefits
US Government debt
Benefits
Interest income
Virtually free of default and liquidity risk
Generally AAA-rated and considered safe
Risks
Interest rate risk
Inflation risk (except TIPS )
Reinvestment risk (except STRIPS )
Typical investor
Seeks income
Generally older
Willing to accept lower yields in exchange for safety
Mortgage-backed securities
Benefits
Monthly income (interest and principal)
Direct or indirect US government backing
Risks
Prepayment risk
Extension risk
Interest rate risk
Reinvestment risk
Inflation risk
Typical investor
Seeks consistent (monthly) income
Generally older
Comfortable with an unknown maturity date
Investment companies
General suitability
Instant diversification
Provides professional management
Risk depends on the type of fund
Growth funds
Growth and income funds
Value funds
Seeks capital appreciation and income
Invests in common stock
Moderate risk potential
Moderate return potential
Example: Thrivent Large Cap Value Fund
Balanced funds
Seeks capital appreciation and income
Invests in stocks and bonds
Moderate risk potential
Moderate return potential
Example: T Rowe Price Balance Fund
Income funds
Seeks income
Invests in stocks and bonds depending on the type of income fund
Risk and return potential depend on the type of income fund
Example: JP Morgan Income Fund
High-yield bond funds
Seeks income
Invests in speculative (junk bonds)
Moderate to high risk potential
Moderate to high return potential
Example: Blackrock High Yield Bond Fund
Conservate bond funds
MBS agency funds
Asset allocation funds
Life cycle funds
Money market funds
Specialized funds
Sector funds
