Identifying suitable investments is part art, part science. You need to understand product characteristics, investor profiles, investment objectives, and risk tolerance. The topics covered in earlier suitability chapters are the “science” behind the concept. Here, we’ll focus on the “art”: how to reason through suitability questions the way the exam expects.
This chapter doesn’t introduce new test topics. Instead, it helps you apply what you already know so you can consistently choose the best answer on suitability questions.
This exam isn’t essay-based. Each question gives you four answer choices. On suitability questions, the correct answer is often not the recommendation you’d make in real life - it’s the best choice among the four options provided.
For example:
A 30-year-old investor with a moderate risk tolerance seeks a growth-oriented investment for their retirement account. What should you recommend?
Using the rule of 100, an average 30-year-old would typically have about 70% in common stock and 30% in fixed-income securities. Their moderate risk tolerance and growth objective point toward a growth stock or a growth stock fund.
But what if these are the answer choices?
A) Money market fund
B) Revenue bond
C) Convertible bond
D) Short index call
None of the choices looks like a growth stock or growth fund. That’s why elimination is so useful on suitability questions: you remove the clearly unsuitable choices until the best remaining option is obvious.
Answer = C) Convertible bond
Start by eliminating the short index call. Short options are generally used to generate income and can involve significant risk. A short call, in particular, has unlimited risk. Options are also short-term instruments, which doesn’t match an investor seeking long-term growth for retirement.
Next, eliminate the money market fund. Money market funds emphasize safety and liquidity and typically offer low returns. They’re most suitable for very conservative investors or short time horizons, and they offer little to no growth potential.
Now consider the revenue bond. Revenue bonds are municipal bonds, which are generally most attractive to investors in higher tax brackets. Also, municipal bonds are not suitable for retirement plans. Finally, bonds typically don’t provide strong capital appreciation, so this choice doesn’t align well with a growth objective.
That leaves the convertible bond. It’s not a perfect match for “growth-oriented,” but it’s the best of the four choices. The bond component provides income and relative stability, and the conversion feature creates a path to growth if the issuer’s common stock rises. It’s also a longer-term investment than the other remaining choices.
On many suitability questions, the “best recommendation” in the real world won’t appear as an answer choice. The exam is often testing whether you can reason through the facts and select the best available option.
Some test questions include extra information. For example, an options question might include six numbers even though you only need two to solve it. That tests your ability to filter out irrelevant details.
Suitability questions work differently. In suitability scenarios, details are rarely random. Each fact is usually a clue that pushes you toward (or away from) certain products.
John Washington is a 52-year-old investor with a $2 million portfolio invested in an S&P 500 index fund, growth funds, and various individual common stocks. He is a vice president at a large tech firm, making roughly $650,000 annually. As he nears retirement, John seeks guidance on diversifying his portfolio. He’s comfortable with his current allocation but is about to receive a $200,000 bonus and seeks your opinion on investing it. What should you recommend?
A) Balanced fund
B) Investment grade bond fund
C) Russell 2000 ETF
D) Municipal bond fund
You’ll see suitability questions written in paragraph form like this. The length can feel distracting, so it helps to track the key facts. Using the exam notepad can be useful for longer scenarios.
For example, you might jot down:
Then choose the answer that best matches these points.
Answer = D) Municipal bond fund
Use elimination first. The easiest choice to remove is the Russell 2000 ETF. The Russell 2000 is a small-cap stock index. Adding more stock to a portfolio that’s already 100% stock doesn’t improve diversification.
Next, consider the balanced fund. Balanced funds typically hold a mix of stocks and bonds (often close to 50/50). This investor already has substantial stock exposure and is looking to diversify, so a product that adds more stock exposure isn’t the best fit.
That leaves two bond funds: an investment grade bond fund and a municipal bond fund. Either would add fixed income and reduce overall portfolio risk, which aligns with “diversifying” as retirement approaches.
The deciding factor is taxes. With $650,000 of annual income, the investor is in the highest tax bracket (37%), regardless of filing status. A municipal bond fund is likely to provide a higher after-tax return than an investment grade bond fund, which is primarily composed of fully taxable corporate bonds.
Notice how each detail mattered:
As discussed earlier, the Financial Industry Regulatory Authority (FINRA) regulates the financial industry and writes the exam questions. The more you understand FINRA’s priorities, the easier it is to predict what the test is looking for.
One of FINRA’s primary goals is protecting investors from fraud and deceptive practices. The industry has a long history of misconduct, from Bernie Madoff to Jordan Belfort. Investor confidence matters - without it, the industry can’t function.
On suitability questions, try to think like a regulator. Regulators focus heavily on the risk a representative exposes a client to. That makes risk one of the most important factors in many suitability scenarios.
Here’s how that approach works in a practice question:
A 70-year-old investor living on a modest company pension and social security inherits $20,000 from a relative. Their current portfolio consists of growth funds and technology funds, which they want to keep in place. Although they are older, the investor prefers an aggressive portfolio. They wish to seek out an income-producing investment to supplement their retirement income. What should you recommend?
A) Investment grade bond fund
B) Growth and income fund
C) Index fund
D) High-yield income fund
Answer = A) Investment grade bond fund
Start by eliminating the index fund, which is most likely a stock index fund (a reasonable assumption). The investor is seeking income, and stock index funds typically aren’t designed to generate high income.
Next, eliminate the growth and income fund. It’s still an equity fund (100% stocks), and the question is specifically asking for an income-producing investment. The remaining two choices are bond funds, which are more directly aligned with an income objective.
Now you’re choosing between two bond funds: investment grade and high-yield. The investor says they prefer an aggressive portfolio, but they’re also 70 and living on modest fixed income sources (pension and Social Security). High-yield bond funds carry higher credit risk. An investment grade bond fund is the more conservative income choice, and it better fits a regulator’s “err on the side of caution” approach.
This is a classic example of choosing the less risky option when two answers could seem plausible.