Sidenote

The purpose of this chapter

The Series 63 focuses primarily on state laws and regulations. However, some test questions may also cover basic characteristics of securities. In particular, suitability can matter when you’re evaluating recommendations and/or applying the Uniform Prudent Investors Act (UPIA) (discussed in the previous chapter).

This chapter is here to give you a working, high-level understanding of the risks, benefits, and typical investors for the most common securities.

If you’ve prepared for the SIE, Series 6, or Series 7 exams, you’ve likely seen most of this material before. Many of the links point to Achievable’s Series 7 program. Even if you haven’t purchased it, you’ll still be able to view a number of the linked pages for free.

This summary section provides each security’s BRTI: benefits, risks, and typical investor.

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

Sidenote

Market capitalization

The size of a company can affect the risk profile of its stock. Smaller companies tend to be riskier, while larger companies are usually more stable. When problems arise, smaller companies often have less capital (money) and fewer resources to absorb losses and keep operating.

Smaller companies’ stocks also tend to trade less frequently than large, well-established companies. That lower trading volume can create liquidity risk.

Company size is commonly measured by market capitalization, calculated as the stock’s market price multiplied by the number of shares outstanding. For example, consider Nike (ticker: NKE), which was trading at roughly $127/share (as of May 2023) with 1.25 billion shares outstanding. Here’s the market cap calculation:

$\text{MC}=\text{Shares outstanding x market price}$

$\text{MC}=\text{1.25 billion x \$127}$

$\text{MC}=\text{\$158.75 billion}$

Nike is considered a large-cap company (discussed further below) and would most likely survive an economic recession given its prominence, resources, and size. That said, size isn’t a guarantee. For example, Lehman Brothers had a market cap of $60 billion in 2007, then filed for bankruptcy in 2008.

In practice questions, a reference to market capitalization is a clue about company size. Most of the time, it’s also a hint about risk (for example, large-cap stocks are generally less risky than small-cap stocks). Here are the common categories:

Mega-cap

• $200 billion or more

Large cap

• Between $10 billion - $200 billion

Mid-cap

• Between $2 billion - $10 billion

Small-cap

• Between $250 million - $2 billion

Micro-cap

• Less than $250 million

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
• 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
• CMOs offer more predictable outcomes

Risks

• Prepayment risk
• Extension risk
• Interest rate risk
• Reinvestment risk
• Inflation risk

Typical investor

• Seeks consistent (monthly) income
• Generally older
• Comfortable with unknown maturity dates

Investment companies

General suitability

• Instant diversification
• Provides professional management
• Risk depends on the type of fund

Sidenote

Breakpoints

Many mutual funds are sold with sales charges (also called loads). These charges compensate financial professionals for selling securities issued by another company. For example, buying a Vanguard fund through a Fidelity brokerage account can result in the customer paying Fidelity a sales charge.

A common type of sales charge is a front-end load, which is charged at the time of purchase. When a front-end load applies, customers may qualify for breakpoints. A breakpoint is a quantity discount: the more the investor purchases, the lower the load. Here’s an example breakpoint schedule:

• $0 - $24,999 - 8.50% sales charge
• $25,000 - $49,999 - 5.00% sales charge
• $50,000 - $99,999 - 3.00% sales charge
• $100,000+ - 1.00% sales charge

Back-end loads are sales charges assessed when an investor sells their shares. This load type is also called a contingent deferred sales charge (CDSC). The longer an investor holds their shares, the lower the sales charge assessed.

What happens if an investor places an order just below a breakpoint? Using the schedule above, suppose an investor wants to purchase $24,000 of the fund. If the financial professional processes the trade as-is, the investor pays the highest sales charge (8.50%). That creates a financial incentive for a registered person to let the order go through without discussing the breakpoint.

If the transaction is processed without notifying the customer about the breakpoint schedule, it’s called a breakpoint sale. This is unethical and can lead to punitive and non-punitive consequences. If an investor is close to a breakpoint, the financial professional must notify them.

If the investor doesn’t have enough funds to reach the breakpoint, they should be offered a letter of intent. This is a pledge from the investor to deposit the shortfall sometime in the next 13 months. Once the letter is signed, the investor automatically receives the reduced sales charge.

Types of funds

Growth funds

• Seeks capital appreciation
• Invests in common stock
• Higher risk potential
• Higher return potential
• Example: American Funds Growth Fund of America

Growth and income funds

• Seeks capital appreciation and income
• Invests in common stock
• Moderate risk potential
• Moderate return potential
• Example: Vanguard Growth and Income 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

Conservative bond funds

• Seeks income
• Invests in investment-grade bonds
• Low risk potential
• Low return potential
• Example: Fidelity Conservative Bond Fund

MBS agency funds

• Seeks income from mortgages
• Invests in MBS from Ginnie Mae, Fannie Mae, Freddie Mac
• Moderate to low risk potential
• Moderate to low return potential
• Example: PIMCO GNMA and Government Securities Fund

Asset allocation funds

• Various asset mixes
• Asset mix may be static or fluid
• Example: Franklin Moderate Allocation Fund

Life cycle funds

• Type of asset allocation fund
• Asset mix becomes more conservative over time
• Example: State Street Target Retirement 2050 Fund

Money market funds

• Seeks preservation of capital
• Small income potential
• Invests in debt securities with one year or less to maturity
• Very low risk
• Very low return potential
• Example: Charles Schwab Value Advantage Money Fund

Specialized funds

• Invests in securities from specific industries or regions
• Moderate to high risk potential
• Moderate to high return potential
• Example: Morgan Stanley India Investment Fund

Sector funds

• Invests in securities from specific industries
• Moderate to high risk potential
• Moderate to high return potential
• Example: Fidelity Select Pharmaceuticals Portfolio

Real estate investment trusts (REITs)

Suitability

• Equity REITs provide capital appreciation
• Mortgage REITs provide income
• Hybrid REITs provide capital appreciation and income
• Provide real estate diversification
• Unlisted and private REITs subject to liquidity risk
• Real estate may hedge against stock market risk

Hedge funds

Suitability

• High liquidity risk
• High risk and return potential
• Suitable only for wealthy, aggressive investors

Direct participation programs (DPPs)

Suitability

• High liquidity risk
• Tax benefits (losses passed through)
• Moderate to high risk and return potential
• Limited partnerships are a common type of DPP