Suitability refers to the risks and benefits of an investment, and it helps determine whether an investment is appropriate for a particular investor. The Series 65 dedicates a significant portion of the exam to suitability-based questions.
As we cover different investments throughout this material, you’ll want to understand the BRTI of each product:
Once you understand these three areas for each investment product, you can make suitable recommendations on the exam and in real-world scenarios.
In this section, we’ll look at the BRTI of common stock.
Generally speaking, there are three benefits associated with common stock:
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.
Because there’s no ceiling on how high a stock’s price can rise, common stock has unlimited gain potential. The higher the market climbs, the more the investor gains. Capital appreciation is the most common form of return from a common stock investment.
Gains are unrealized until the investment is sold. Stock prices can fluctuate significantly; for example, consider the stock market’s performance in the early stages of COVID-19 in the United States. The S&P 500 was down 12.5% in March 2020, then rebounded and increased by 12.6% in April 2020. For context, the S&P averages around a 10% return annually. In other words, the market moved about a year’s worth of “typical” performance in a single month.
The key point is that investors must sell a security to “lock in” capital gains. Once the investment is sold, the gain becomes a realized gain. Until then, the gain can disappear if the market declines.
Growth stocks are most likely to provide capital appreciation. These are stocks of companies focused on growing business revenue, typically at a faster rate than the overall economy. Many companies begin as growth companies as they expand operations and revenue. While not necessarily considered growth companies today, companies like McDonald’s, Walmart, and Home Depot were growth companies in their early stages. Today, they’re large companies that are likely beyond their most significant growth phase.
Some large, well-established companies are still considered growth companies. While Amazon is wide-reaching and well-established, the company continues expanding its business operations and entering new industries. Amazon uses business profits to expand through mass hiring, acquisitions, and ongoing improvements to 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 because they prefer to reinvest profits into expansion. If the company believes it can create more value by reinvesting earnings back into the business, it may choose not to pay dividends.
Income from cash dividends is another way to earn a return on common stock. While growth companies rarely pay dividends, larger, well-established companies that are beyond their major growth phase often do. McDonald’s, Walmart, and Home Depot all pay quarterly cash dividends to their investors.
Many large dividend-paying companies focus on retaining or slowly building market share rather than pursuing major expansions. For example, Walmart already has a global presence and generates around $500 billion annually in revenue, making it a blue chip company.
Because Walmart isn’t spending as much of its earnings on major expansion, it can pay a larger portion of earnings to shareholders. In fact, its dividend payout ratio is usually around 40% annually. This ratio compares annual earnings to how much is paid out to investors. Here’s the dividend payout ratio formula:
Continuing with Walmart, let’s look at its 2019 (fiscal year) financials and calculate the dividend payout ratio:
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 meaningful revenue, it’s harder to argue that its stock is a “good deal.” Value companies often pay dividends that are large relative to their stock price.
Investors can build large dividend-paying stock positions and live off the income. This can be especially useful for retired investors who want to replace employment income with dividend payments.
Dividends are not guaranteed, which affects both risk and return. Companies can reduce or completely cut cash dividend payments at any time. This often happens during 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 reduced dividend exists, it also comes with a benefit. Because dividends can be cut, common stock dividend yields are typically higher than bond yields. As you’ll learn later, companies are legally obligated to pay bond interest (or they can be sued). This is another example of the idea that higher risk can come with higher return potential.
Stock investments 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. If you’ve heard older relatives talk about how inexpensive things were when they were younger, they’re describing inflation.
Over the long term, the stock market generally outpaces inflation. As prices of goods and services rise, stock prices tend to rise as well, often at a faster rate. For example, grocery prices may increase over the next 10 years, but stock values will likely grow more than those price increases. So, if you want protection from rising prices, the stock market may help preserve purchasing power over time.
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 a form of systematic risk. We’ll discuss non-systematic risks later in this chapter.
Market risk is a type of systematic risk. It occurs when an investment falls in value due to a broad market or economic circumstance. The Great Recession of 2008 is a good example. The S&P 500, an index (average) of 500 large domestically traded stocks, fell by 38% in 2008. When the market declines that much in one year, it’s a sign that nearly everything is falling in value.
Even Apple (symbol: AAPL) performed poorly in 2008. Although the first iPhone had been released in 2007, the company’s stock fell 56%. To put that in perspective, if you invested $1,000 in Apple on January 1, 2008, you would have $440 left at the end of the year. Apple was a strong company with a growing business model, but its stock value still fell dramatically due to the economic environment. That’s market risk.
Although there were some exceptions, most stock prices fell drastically in 2008 due to market risk. Even well-diversified portfolios, which often “weather the storm” when faced with various risks, lost significant value. Investors cannot use diversification to avoid market risk. When an event negatively affects the overall market, it doesn’t matter how diversified an investor is.
We covered the basics of inflation risk, sometimes referred to as purchasing power risk, earlier in this chapter. Now let’s add a bit more detail.
If you’ve noticed prices slowly rising over time, that’s inflation. For example, the median home price in 1950 was around $7,000 but rose to $120,000 50 years later in 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). 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). When the Series 65 exam refers to CPI, it’s referring to inflation.
Normal levels of inflation (2-3% annually) are healthy and expected. Higher-than-expected inflation can create problems for the economy. When prices rise faster than expected (for example, in late 2021-2022), corporations may struggle to maintain profits. Supplies become more expensive, businesses raise prices, and demand often falls. Bottom line: high inflation is typically a short-term problem for common stocks (market values may fall).
Over the long term, the stock market tends to outpace inflation. Inflation may occur, but the Federal Reserve can take action to prevent prices from rising too much. Before late 2021/2022, the last period of significant U.S. inflation was in the 1980s. Eventually, prices stabilized and the economy recovered. Because inflation tends to occur in shorter bursts, the stock market typically experiences a higher long-term rate of return than the inflation rate.
Market risk and inflation risk are the two major types of systematic risk you’ll need to know. Market risk is referenced most often, but remember that higher inflation can also affect common stocks in the short term.
Now we’ll look at non-systematic risk, which affects specific investments, companies, or sectors.
When a company runs into financial problems, it faces financial risk. This is often due to being over-leveraged, meaning the company borrowed too much money. Tesla (symbol: TSLA), for example, faced financial risk for many years. Even if a company’s product is in high demand, it can still face serious problems if it owes too much money to creditors. Stock prices often decline when these issues arise, which can significantly affect a common stock investment.
Business risk is similar to financial risk, but it focuses on the company’s operations rather than its debt levels. Business risk occurs when a company struggles with its core business. Radio Shack is a good example. Although some stores still exist today, Radio Shack’s business peaked in 1999. Over time, it lost revenue and customers to companies like Best Buy and Amazon and failed to adapt to changing technology. Eventually, Radio Shack filed for Chapter 11 bankruptcy in 2015, and again in 2017 after restructuring its finances. When a common stock investment faces business risk, the stock value tends to decline.
When a company faces challenges due to current or potential government regulation, investors face regulatory risk. When Mark Zuckerberg (CEO of Meta (Facebook)) was asked to testify to Congress regarding privacy concerns, Meta encountered regulatory risk. If lawmakers determined that new regulations were needed to address privacy issues, it could negatively affect Meta’s business. The company might need to spend millions of dollars updating training protocols, parts of its website, and general business practices. Even if regulation benefits society, it can still drive down the value of the company’s stock.
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 that a large amount of trading occurs on exchanges and that it’s usually easy to buy or sell stocks there.
Not all publicly traded stocks trade on exchanges. Many smaller or start-up companies trade in the OTC markets. Without going into too much detail, OTC stocks tend to have lower trading volume than exchange-listed stocks. As a result, it may be difficult for an investor to sell a lesser-known OTC stock.
Whenever an investor has trouble turning stock into cash, they face liquidity risk, sometimes referred to as marketability risk. To sell an investment with little demand, the investor may have to lower the 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 performance of any one investment.
When an investor lacks diversification, they face concentration risk, which amplifies the non-systematic risks discussed in this section. For example, exposure to financial risk is much higher if an investor owns only 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 category.
Generally speaking, investing in common stock is often more appropriate for younger investors. Stocks are subject to numerous risks, and the market can fluctuate dramatically. Investors who cannot afford - or cannot tolerate - large swings in account value should generally avoid heavy stock exposure.
Older investors can and often should keep a portion of their portfolio in common stock. However, their common stock allocation typically declines as they age. Many investors use the rule of 100 as a starting point. Under this rule, you subtract your age from 100 to estimate an appropriate stock allocation. 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 typically allocate to stocks and the more they allocate to fixed-income securities like bonds. Age isn’t the only suitability factor, but the rule of 100 is a useful starting point.
From there, other factors determine whether a recommendation is appropriate. For example:
Another reason older investors often reduce stock exposure is time horizon. In the short term, the stock market is 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, however, investors can reasonably expect the stock market to increase. Over the past 100 years, there have been numerous bear markets and major declines. The Market Crash of 1929, which led to the Great Depression, and the Great Recession of 2008 are examples of events that caused the market to plunge. Even after large declines, the market recovered and grew beyond previous highs.
The COVID-19 stock market recovery was relatively quick: the S&P 500 reached a new all-time high in September 2020, less than 6 months after the fastest decline in history. Recoveries may take a few months or several years, but history suggests that a recovery eventually occurs. If it doesn’t, there are broader economic concerns beyond investment performance.
The typical common stock investor may be seeking capital appreciation, income, or both. Some stocks primarily offer capital gain potential, which is common for smaller growth companies or larger companies that are expanding operations significantly. As discussed earlier, Amazon is an example of a growth company.
Other companies, such as McDonald’s, Walmart, and Home Depot, pay quarterly dividends to shareholders. While these companies may not have the same growth potential as a company like Amazon, investors can still earn meaningful returns by collecting dividends over time. Their stock prices can also continue to grow, although typically not as rapidly as a growth company.
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