Identifying suitable investments is part art, part science. Understanding product characteristics, investor profiles, investment objectives, and risk tolerance is vital. The topics discussed in previous suitability-based chapters represent the “science” behind the concept. Now, we’ll cover the “art.” You won’t learn any new test topics in this chapter, but it will help you build test-taking skills that will help you consistently answer suitability questions correctly.

Eliminating wrong answers

This exam is not an essay-based test. Questions are always presented with four possible choices. The answer to a suitability question often differs from the one a test taker originally seeks. 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 should have 70% of their portfolio invested in common stock, with the other 30% invested in fixed-income securities. Their risk tolerance and need for a growth-oriented investment further point to a growth stock or growth stock fund. However, what if these are the answers?

A) Money market fund

B) Revenue bond

C) Convertible bond

D) Short index call

Unfortunately, there is no answer resembling a growth stock or related fund. That’s why it’s always best to perform a process of elimination with suitability-based questions. With that being said, what do you think the answer is?

(spoiler)

Answer = C) Convertible bond

Given its risk and lack of growth opportunity, we can eliminate the short index call. Short options provide income and often are subject to significant risk. Specifically, short calls are subject to unlimited risk. Additionally, options are short-term investments unsuitable for investors seeking long-term growth.

We can also eliminate the money market fund. These pay low levels of income in return for safety and are only suitable for very conservative investors or investors with short-term time horizons. There is no growth opportunity with this fund.

The revenue bond is a type of municipal bond suitable for investors in high tax brackets. Additionally, municipal bonds are not suitable for retirement plans. The security is also unlikely to result in capital gains (growth), making this another choice that can be eliminated.

We are left with the convertible bond. While it’s not the best recommendation for this scenario, it’s the best of the four answers provided. The bond will primarily provide income, but its conversion feature offers growth opportunities should the common stock of the same issuer rise. Bonds are long-term investments, and this is the only choice that provides reasonable growth opportunities, making it the best answer.

The best recommendation may not be the answer to many suitability questions. The test writers formulate questions this way by design. They’re trying to see if you can reason through the scenario and find the best answer provided. Demonstrating your ability to find the best of the offered choices ensures you understand suitability beyond memorizing the basics (e.g., young investors seeking growth stocks).

Everything is important

Test questions are sometimes loaded with too much information. For example, you could encounter an options question containing six different numbers, and only need to use two to get the right answer. Question writers are testing your ability to “filter out” the unimportant information, which is an essential skill in the real world. Investors commonly overload financial professionals with more information than what’s needed.

You’ll want to approach suitability-based questions in the exact opposite manner. Everything provided in these questions is important, one way or another. Each piece of information is a “breadcrumb” that attempts to lead you to the correct answer.

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 likely come across a few suitability questions in paragraph form like this. Don’t let the length intimidate you! You can identify the right answer if you track the information provided. Using your notepad on the exam can be useful for long questions like this. For example, you could jot down the major parts:

52 years old
$2 million portfolio
Invested 100% in stock
$650,000 annual income
Seeks diversification
Comfortable with growth allocation
How to invest a $200,000 bonus?

Whichever answer matches these points the most will be the best answer. What would you choose?

(spoiler)

Answer = D) Municipal bond fund

Let’s first approach the question using a process of elimination. The most straightforward choice to eliminate should be the Russell 2000 ETF. The Russell 2000 is a small-cap stock index. Will investing further in a 100% common stock investment increase diversification for the investor? No.

It ought to be pretty clear the investor should invest their bonus into fixed income securities. With a $2 million portfolio all invested in stock, an investment in bonds will diversify the portfolio. Balanced funds typically allocate roughly half of the portfolio assets into stock and half into bonds. Given the investor doesn’t need more stock investments, we can eliminate this choice.

We are now left with the two bond funds. Both will provide diversification and make the portfolio less risky, which is a good move for a soon-to-be-retired investor with an aggressive portfolio allocation. The municipal bond fund is the better choice for one reason - the investor’s income. $650,000 of annual income puts the investor in the highest tax bracket (37%), regardless of their filing status (individual or joint). The municipal bond fund will most likely provide the highest after-tax return, as compared to the investment grade bond fund that is primarily composed of fully taxable corporate bonds.

As demonstrated in the last question, every piece of information provided was important in one way or another. Take everything provided in suitability questions into consideration and find the answer that fits the best.

Think like a regulator

The North American Securities Administrators Association (NASAA) regulates the financial industry and is responsible for writing the test questions. The more you know about the organization responsible for creating the exam, the more you can think about suitability from their perspective.

Protecting investors from fraud and deceit is NASAA’s primary goal. Unfortunately, the finance industry is riddled with a checkered past. From Bernie Madoff to Jordan Belfort to Elizabeth Holmes, there are plenty of cautionary tales relating to everything from harmful recommendations to blatant lying & stealing. Investors must have confidence in the financial industry; otherwise, it will collapse.

When approaching a suitability question, try to put on your “regulator hat.” Regulators are often most concerned with the risk financial representatives expose their clients to. Therefore, risk is likely the most crucial aspect of any suitability question. You should only recommend an aggressive investment if a suitability question states an investor is comfortable with risk. Avoid risk if it’s clear the investor is conservative or risk-averse. The best answer is likely the less risky option if you’re between two choices. It’s good practice to “err on the side of caution” when making recommendations.

Let’s look at how to implement this approach using 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

What would you answer?

(spoiler)

Answer = A) Investment grade bond fund

First, we can eliminate the index fund, which is most likely a stock index fund (a safe assumption). The investor seeks income, and stock index funds typically make few distributions.

A growth and income fund is entirely invested in stocks, but roughly half are growth-oriented, and half are income-oriented. With the investor seeking income and the two other choices being bond funds (solely income focused), this choice can be eliminated.

The question states the investor is aggressive, but they’re also older and live on a modest retirement plan and social security income. Neither of these retirement sources is likely to provide high levels of income to the investor. While it could be argued a high yield income fund could be suitable given their risk tolerance, an investment grade bond fund is the better choice given the investor’s age and aggressive allocation in their current portfolio.

The previous question is a great example of “erring on the side of caution.” If stuck between two choices, you should always go with the less risky answer.