Common stock suitability
Suitability refers to the risks and benefits of an investment, and is used to determine if an investment is appropriate for an investor. The Series 65 dedicates a significant portion of the exam to suitability-based questions.
When we cover various investments throughout this material, it’s important to understand the “BRTI” of these products:
- B - Benefits
- R - Risks
- TI - Typical Investor
Once you master these three concepts for each investment product, you can consistently make suitable recommendations on the exam and in the real world.
In this section, we’ll explore the BRTI of common stock. Let’s dive in!
Benefits
Generally speaking, there are three benefits associated with common stock:
- Capital appreciation
- Dividend income
- Hedge against inflation
Capital appreciation
Capital appreciation, also known as growth or a capital gain, occurs when an investment’s value rises above its original purchase price. For example, a stock purchased at $50 and sold at $75 results in a $25 capital gain. With no ceiling to how high the stock market can climb, common stock has unlimited gain potential. The further the market climbs, the more the investor gains. This is the most common form of return from a common stock investment.
Gains are unrealized until an investment is sold. The stock market can fluctuate considerably; for example, the stock market performance in the early stages of COVID-19 in the United States. The S&P 500 was down 12.5% in March 2020, while it rebounded and increased by 12.6% in April 2020. For context, the S&P averages around a 10% return annually. The stock market was moving as much as it does in a year, but in the span of a month. Bottom line - investors must sell a security to “lock in” capital gains, which is known as a realized gain. Until that occurs, the investor could be in for a wild ride.
Growth stocks are most likely to provide capital appreciation. These are stocks of companies aimed at growing their business revenue, typically at a faster rate than the economy. Every new business is a growth company attempting to expand its business operations and revenue. While not necessarily considered as such today, companies like McDonald’s, Walmart, and Home Depot were growth companies in their early stages. Today, these are large companies that are most likely beyond their significant growth phase.
Some large and well-established companies are still considered growth companies. While Amazon is wide-reaching and well-established, the company is still expanding its business operations and attempting ventures in new industries. Amazon uses its business profits to expand its business through mass hiring of new employees, buying out other companies, and continually improving their current operations.
Amazon has never paid a cash dividend to its stockholders. Cash dividends represent corporate earnings shared with investors. Growth companies like Amazon generally don’t pay dividends so they can spend their profits on business expansion. If the company believes it can make more money for its investors by reinvesting earnings back into the business, why would it pay a dividend?
Dividend income
Income from cash dividends is the other way to make money on common stock. While growth companies rarely pay dividends, larger, well-established companies beyond their growth phase usually do. McDonald’s, Walmart, and Home Depot all pay quarterly cash dividends to their investors.
Many large dividend-paying companies attempt to retain or slowly build their market share, but significant business expansions are typically not in their plans. Think about it - how much do you expect Walmart’s business to grow? They already have a global presence and make around $500 billion annually in revenue, making them a blue chip company.
Because Walmart isn’t spending significant amounts of its revenue on business expansion, they pay a large chunk of its earnings to shareholders. In fact, their dividend payout ratio is usually around 40% annually. This ratio measures the annual earnings of the company versus how much is paid out to investors. Here’s the dividend payout ratio formula:
Continuing with Walmart, let’s look at their 2019 (fiscal year) financials and calculate their dividend payout ratio:
- Annual dividends paid (per share): $2.11
- Annual earnings made (per share): $5.19
What is Walmart’s dividend payout ratio?
Answer: 40.6%
Value companies are also known for paying cash dividends to shareholders. If a stock is trading at a “bargain,” it’s a value stock. This is most likely to occur with larger, well-established companies. If a company doesn’t have a successful business model or make a fair amount of revenue, it’s more difficult to consider its stock a “good deal.” Value companies often pay dividends that are large in comparison to their stock price.
Investors can build large dividend-paying stock positions and live off the income. This is a great benefit for retired investors, who can replace their employment checks with dividend payments.
Dividends are not guaranteed, which has consequences for risk and return. Companies can reduce or completely cut cash dividend payments at any time. This typically happens in economic downturns; many companies reduced or ended dividend payments in the Great Recession of 2008 and throughout the COVID-19 crisis.
While the risk of a slashed dividend exists, it also comes with a benefit. Due to this risk, common stock dividend yields are typically higher than bond yields. As you’ll learn later in this material, companies are legally obligated to pay bond interest payments (or they’ll be sued). The “more risk means more return potential” mantra is proven true again.
Hedge against inflation
Stock investments are also a great hedge against inflation. Inflation occurs when general prices across the economy rise, rendering the purchasing power of the US Dollar downward. Have your grandparents or an older relative ever talked about how cheap certain things were when they were young? That’s inflation.
The stock market generally outpaces inflation over the long term. As prices of goods and services go up, stock prices tend to rise at a faster rate. For example, prices of goods at the grocery store may go up over the next 10 years, but stock values will likely outpace that growth. Therefore, if you want to have protection from rising prices, the stock market may be a good place to keep your money.
Systematic risks
Risks can generally be broken down into two main categories: systematic and nonsystematic. When an event or circumstance negatively affects the overall market, it’s due to a form of systematic risk. We’ll discuss non-systematic risks later in this chapter.
Market risk
Market risk is a specific type of systematic risk, which occurs when an investment falls in value due to a market or economic circumstance. The Great Recession of 2008 is a good example of market risk. The S&P 500, which is an index (average) of 500 large domestically traded stocks, fell by 38% in 2008. When the market declines by that much in one year, it’s a sign that nearly everything is falling in value.
Even Apple (symbol: AAPL) had a terrible performance in 2008. Although the first iPhone had just been released in 2007, the company’s stock fell 56%. To put this in perspective, if you invested $1,000 in Apple on January 1st, 2008, you would have $440 left at the end of the year. Apple was a good company with a growing business model, but its stock value fell dramatically due to the economic environment. This is an example of market risk.
Although there were some exceptions, most stock prices fell drastically in 2008 (due to market risk). Even well-diversified portfolios, which usually “weather the storm” when faced with various risks, lost significant value. Investors cannot use diversification as a way to avoid market risk. When an event or circumstance negatively affects the general market, it doesn’t matter how diversified an investor is.
Inflation risk
We covered the basics of inflation risk, sometimes referred to as purchasing power risk, earlier in this chapter, but let’s dive a bit deeper into this concept. If you’ve noticed prices slowly going up over time, this is inflation. For example, the median home price in 1950 was around $7,000 but rose to $120,000 50 years later in the year 2000. This is a result of inflation. which occurs naturally over time at an average rate of 2-3% annually.
The government measures inflation through the CPI (consumer price index). Every month, the U.S. Bureau of Labor Statistics captures price changes of goods and services. When prices rise on average, CPI rises (and vice versa). When the Series 65 exam refers to CPI, they’re referring to inflation.
Normal levels of inflation (2-3% annually) are healthy and expected. If inflation levels are higher, it can create problems for the economy. When prices go up more than expected (for example, in late 2021-2022), corporations have a tough time maintaining their profits. Think about it - supplies get more expensive, which forces businesses to raise their prices, which generally drives down demand for their products. Bottom line: high levels of inflation are a short-term problem for common stocks (market values will fall).
Over the long term, the stock market tends to outpace inflation. Inflation may occur, but the Federal Reserve will take action to prevent prices from rising too much. The last time the US experienced significant levels of inflation prior to late 2021/2022 was in the 1980s. Eventually, prices stabilized and the economy recovered. Because inflation tends to last for short periods of time, the stock market typically experiences a higher rate of return than the rate of inflation.
Market risk and inflation risk are the two major types of systematic risk that you’ll need to be aware of. Market risk is the most commonly referenced, but keep in mind higher inflation levels can affect common stocks in the short term.
Non-systematic risks
We’ll now dive into types of non-systematic risk, which affect specific investments or sectors.
Financial risk
When a company runs into financial problems, they face financial risk. This is typically due to being over-leveraged, which means the company borrowed too much money. Tesla (symbol: TSLA), for example, faced financial risk for many years. Even if the company’s product is in high demand, they could still face significant problems if they owe too much money to creditors. Stock prices tend to decline when these problems occur, which could significantly affect a common stock investment.
Business risk
Business risk is similar to financial risk, but slightly different. Instead of financial problems due to large amounts of debt, business risk occurs when a company is having difficulty with its general business. Radio Shack is a good example of how this risk can be a huge problem. Although there are some stores still around today, Radio Shack’s business peaked in 1999. Over the years, they lost revenue and customers to companies like Best Buy and Amazon, while failing to evolve with the changing technological landscape. Eventually, Radio Shack filed for Chapter 11 bankruptcy in 2015, and again in 2017 after restructuring their finances. When a common stock investment faces business risk, it drives the stock value downward.
Regulatory risk
When a company faces challenges due to a current or potential government regulation, investors experience regulatory risk. When Mark Zuckerberg (CEO of Meta (Facebook)) was asked to testify to Congress regarding privacy concerns, Meta encountered regulatory risk. If our politicians determined regulations were needed to prevent privacy-related problems, it would negatively affect Meta’s business. The company would be forced to spend millions of dollars updating training protocols, aspects of its website, and general business practices. While it may be good for society, social media regulations would drive down the value of Meta’s stock.
Liquidity risk
Many common stocks trade on exchanges, like the New York Stock Exchange. You’ll learn more about the stock market later in this material. For now, assume a significant amount of trading occurs on exchanges and that it’s easy to buy or sell stocks there.
Not all publicly traded stocks trade on exchanges. Many smaller or start-up companies are traded in the OTC markets. Without going into too much detail, stocks trading in the OTC markets tend to have less trading volume than those that trade on exchanges. As a consequence, it may be difficult for an investor to sell a lesser-known stock trading in the OTC markets. Whenever an investor has trouble turning their stock into cash, they face liquidity risk, sometimes referred to as marketability risk. In order to sell an investment with little or no demand, it may require the investor to drop their asking price substantially.
Here’s a video breakdown of a practice question on non-systematic risks:
In summary, these are the non-systematic risks that affect specific investments or sectors or the market. Unlike systematic risks, non-systematic risks can be reduced through diversification. The more investments an investor owns, the less they rely on the benefits and risks of one particular investment. When an investor lacks diversification, they are subject to concentration risk, which amplifies the non-systematic risks we discussed in this section. For example, an investor’s exposure to financial risk is especially significant if they’re only invested in one company with large debt levels. The risk is concentrated and amplified!
For the exam, you’ll need to know the two big categories (systematic vs. non-systematic) and which risks fall into each of those categories.
Typical investor
Generally speaking, investing in common stock is a young person’s game. As we’ve already discussed, stocks are subject to numerous risks and the stock market can experience wild fluctuations. Investors who cannot afford or mentally cope with significant account value fluctuations should avoid stocks. The older an investor, the more likely they’re living on a fixed income and cannot afford to lose large amounts of money.
Older investors can and probably should keep a portion of their portfolio invested in common stock. However, their common stock allotment should decline as they age. Many investors use the rule of 100 to determine the appropriate portfolio allotment for stock. According to the rule, investors should subtract their age from 100 to find the appropriate amount of common stock for their portfolio. For example:
| Age | Stock % | Bond % |
|---|---|---|
| 30 | 70% | 30% |
| 45 | 55% | 45% |
| 60 | 40% | 60% |
| 70 | 30% | 70% |
The older an investor is, the less money they should have invested in stocks and the more they should invest in fixed-income securities like bonds. While age isn’t the only suitability factor, the rule of 100 is a great starting point for recommendations. From there, other factors determine if the recommendation is appropriate. For example, it could be suitable for an 80-year-old investor to have 80% of their portfolio in stock if they have a large amount of assets and aren’t relying on the portfolio for living expenses. Or, a 20-year-old may only be suitable for 20% of their money in stocks if they’re disabled and living on social security. Age is one of many suitability factors.
Another reason older investors tend to avoid large investments in stock is the time horizon. In the short term, the stock market is very unpredictable. COVID-19 is a great example of this. In late 2019 and early 2020, the stock market was near all-time highs, but then experienced the fastest market decline in history in March 2020. The short-term outlook is nearly impossible to predict.
Regardless, investors can reasonably expect the stock market to increase over long periods of time. Over the past 100 years, there have been numerous bear markets and large declines. The Market Crash of 1929, which led to the Great Depression and the Great Recession of 2008 are examples of circumstances that resulted in a plummeting stock market. No matter how large the decline, the market recovered and grew beyond its previous highs. The COVID-19 stock market recovery didn’t take long, as the S&P 500 attained a new all-time high in September 2020, not even 6 months after the fastest decline in history. Recoveries may take a few months or several years, but history tells us a recovery will eventually occur. If it doesn’t, we have bigger things to worry about!
The typical common stock investor could be seeking capital appreciation, income, or both. Some stocks only have capital gain potential, which is common for smaller growth companies or larger companies expanding business operations significantly. As we discussed earlier, Amazon is a good example of a growth company.
In that same section, we also discussed how companies like McDonald’s, Walmart, and Home Depot pay quarterly dividends to shareholders. While these companies don’t have as much growth potential as companies like Amazon, investors can make significant returns by collecting dividend payments over time. Additionally, their stock prices can continue to experience growth (although typically not as much as a growth company).
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