Client data

Registered representatives must know their customers well to make suitable recommendations. New account forms ask several detailed questions to gain a complete picture of a client’s financial situation, including:

• Annual income
• Net worth
• Tax status
• Liquidity needs
• Stage in life
• Investment objective
• Risk tolerance
• Investment experience
• Investment goals

This suitability information can be broken down into two categories: financial and non-financial considerations.

Financial considerations

When a suitability attribute is related directly to money, it’s a financial consideration. These are the financial considerations to be knowledgeable about:

Annual income

The amount of money an investor brings in from employment, investment income, or other sources directly influences their investing abilities and risk tolerance. The more money made, the more that can be invested in the market and saved for various goals (child’s education, retirement, etc). Because of the extra money invested, aggressive investment strategies can be pursued. If an investor is saving more money than needed to meet their goals, they can afford to take additional risks with the “extra” funds in pursuit of higher returns. Additionally, annual income relates directly to liquidity. An investor making a significant amount of income can consider investing in securities with less liquidity (like municipal bonds and limited partnerships). The more ongoing income an investor makes, the less they’re worried about locking their current money in illiquid investments.

Investors with lower annual incomes have less money to invest and save for specific goals. Therefore, taking significant risks with invested capital may not be prudent. If a substantial market decline occurs, it could jeopardize the ability to meet important goals. Investors with lower income levels should also avoid securities with high liquidity risk if they may need to liquidate investments to pay for living expenses.

In the common stock chapter, we learned about income statements for corporations. Personal income statements exist as well, which document cash for individuals. An example of this type of statement:

When inspecting an investor’s income statement, keeping an eye out for red flags is important. In this example, the investor spends a significant amount on rent while only saving $700 monthly. It would be a good idea to question the investor’s expenses and see if there was an opportunity to reduce costs. Of course, the income statement only tells part of the picture. This investor could have a significant amount of money stashed in a bank account or in investments that don’t pay income, which would not be accounted for on an income statement.

Net worth

In the common stock chapter, we learned about corporate balance sheets, which determine a company’s net worth. Individuals can create their own versions to determine personal net worth by comparing assets and liabilities. This is an example of a personal balance sheet:

Assets are items owned by the person, which include homes, automobiles, investment accounts, checking accounts, jewelry, and other items of value. Liabilities are debts the person owes, including mortgages, car loans, credit card balances, and other loans. The person’s net worth is determined when liabilities are subtracted from assets.

The higher an investor’s net worth, the more suitable they are for higher-risk investments. When an investor’s net worth is in the millions (or more), they have enough capital to live comfortably, especially in retirement. A $1,000,000 portfolio yielding 4% could provide $40,000 per year in income without touching the principal. When an investor has millions in investment accounts, they have extra capital they can expose to significant risk to achieve higher return potential. As the old saying goes, “it takes money to make money.”

The lower an investor’s net worth, the more suitable they are for lower-risk investments. A low net worth could indicate a few things, including low annual income, high debt levels, or significant family obligations. Investors in these situations cannot save large amounts of money and should only take on a little risk.

Tax status

An investor’s tax status can provide insights into an investor’s financial situation. In the US, we operate under a marginal income tax system. The more income one makes, the higher the marginal tax bracket. As of the tax year 2024, these are the income tax brackets for individuals and those filing jointly:

Do not memorize these tax brackets; this chart is only for context.

The more income, the higher their marginal tax bracket. When an investor’s tax bracket is detailed in a suitability question, it provides insight into annual income and potentially suitable investments. When an investor is in the 37% tax bracket, it can be safely assumed they make more than half a million dollars in earned income annually. Investors with incomes this large can likely save significant sums of money and aggressively invest in the market with their disposable income.

Income tax brackets influence after-tax returns for many types of investments. First, interest income (from debt securities) is taxable at the investor’s tax bracket. That’s why municipal bonds, which pay tax-free interest income if purchased by residents of the municipality, are suitable for wealthy investors at high tax brackets. Corporate bonds are fully taxable, and US Government bonds are federally taxable (exempt from state and local taxes), resulting in increased tax liabilities for investors with large annual incomes.

Short-term capital gains are also taxable at the investor’s tax bracket, providing a big incentive for investors at high tax brackets to pursue long term capital gains. Long-term capital gains, assessed on gains made when holding a security for more than one year, are taxable at 15% for most investors and 20% for investors at the two highest tax brackets. Dividends from common and preferred stock are taxable at long-term capital gains tax rates, which is why wealthier investors seeking income may be suitable for these investments.

Liquidity needs

Liquidity is the ability to turn an investment or asset into cash easily. An investor’s financial situation and stage in life dictate their liquidity needs. For example, older investors living on fixed incomes typically should avoid investing in securities with liquidity risk. If a large unforeseen liability (like medical bills) occurs, they must be able to cash in investments if necessary to pay for those costs. Investors with these concerns should avoid difficult-to-sell securities, which include:

• Limited partnerships
• Hedge funds
• Penny stocks
• Unlisted and private REITs
• Municipal bonds

Liquidity concerns are not just relegated to older investors. Younger investors living on disability, unemployed investors with children, and investors making large purchases within a short time frame (like a home purchase) are examples of investors that should avoid securities with liquidity risk. In general, these securities are suitable for investors concerned with short-term liquidity:

• Money market funds
• Treasury bills
• Short term CDs

An investor with a large annual income or high net worth would not be as concerned with liquidity, and therefore could invest in securities subject to higher levels of liquidity risk.

Non-financial considerations

When a suitability attribute is not related directly to money, it’s a non-financial consideration. These attributes measure sentiments, goals, and personal qualities. Here are the non-financial considerations to be knowledgeable about:

Stage in life

There are several stages in a person’s life: childhood, adolescence, adulthood, middle age, and senior years. As discussed previously, younger investors tend to be employed, are more aggressive investors, and invest large sums of money in stocks. With employment income sustaining their living costs, young investors typically do not seek income from investments. Additionally, most will not need investment income for living expenses until retirement, allowing investments in riskier growth-oriented investments. The longer the time horizon, the longer the investor has to recoup losses.

Older investors tend to be retired, are more conservative (risk averse), and invest large sums of money in fixed-income securities. Without employment income, older investors tend to pay for living expenses with retirement benefits (defined benefit plans, defined contribution plans, IRAs, and annuities), social security, and income from investments (like bonds, preferred stock, and mutual funds that invest in these securities). These investors tend to have shorter time horizons, resulting in taking less risk and avoiding riskier growth-oriented investments.

Investment objective

Earlier in this unit, we discussed the specific investment objectives. Registered representatives help clients determine their investment objective based on their suitability information.

Risk tolerance

We’ve loosely discussed risk tolerance throughout the Achievable material. There’s a spectrum of risk tolerance, from low-to-no risk tolerance (conservative investors that want to avoid risk) to high-risk tolerance (aggressive investors seeking risk for higher return potential). Discussing risk with clients is always very important. While significant returns are the goal of every investor, high levels of risk are typically required to obtain them. Investors who want to chase large returns must be aware of the possibility of significant portfolio losses should the market move against them.

Investment experience

Investment experience is not the most critical suitability characteristic, but it may determine the complexity of the securities recommended to investors. We’ve learned about many complicated investments, including hedge funds, plus leveraged and inverse ETFs. Before placing an investor into these complex securities, registered representatives should ensure their client understands how these investments work. Investment experience plays right into this dynamic; those who understand market dynamics and general finance principles are typically the only ones suitable for these investments.

Investment goals

At various stages in a person’s life, certain goals become prioritized. In almost every circumstance, goals require funding, which can be attained through investing. Establishing goals is important when creating a suitability profile for a client. The products and securities recommended are often significantly influenced by the goals set. Examples include:

• Funding a child’s education
• Saving for retirement
• Paying off debt
• Making a real estate purchase
• Financing a small business
• Financially supporting family members

The longer the time horizon for the goal, the more risk an investor may expose themselves in exchange for return potential. For example, a 25-year-old saving for retirement or a couple saving for a young child’s college education involves lengthy investment periods. When the time horizon goes beyond 10 or 20 years, there’s enough time to recover from unexpected market declines. The investing markets may have their ups and downs, but investors can expect the markets to generally rise over long periods of time. For example, the 1-year S&P 500 return from April 2019 to April 2020 was approximately -3%, while the 30-year annualized return from April 1990 to April 2020 was roughly 9.5% (including dividend reinvestments).

Shorter time frames require investors to be safer with their investments. With the unpredictability of the market or the economy, significant losses can occur on aggressive investments in the short term. For example, let’s assume an investor has $50,000 to make a deposit on their first home purchase, which will occur in the next 3 months. If the $50,000 was invested in an S&P 500 ETF in January 2020, they would’ve lost almost $15,000 (the S&P 500 was down nearly 30% from early January 2020 to end of March 2020). $35,000 would be left for the investor to make a down payment, and they might lose the opportunity to buy the house if they needed $50,000. This is why it’s so important to avoid risk for short-term goals. In this example, the investor should’ve considered a short term debt security like a Treasury bill or a money market fund.