Identifying suitable investments is part art, part science. You need to understand product characteristics, investor profiles, investment objectives, and risk tolerance. The topics covered in earlier suitability chapters are the “science” behind the concept. Here, we’ll focus on the “art”: how to reason through suitability questions the way the exam expects.
This chapter doesn’t introduce new test topics. Instead, it helps you apply what you already know so you can consistently choose the best answer on suitability questions.
This exam isn’t essay-based. Each question gives you four choices, and your job is to pick the best one.
On suitability questions, the correct answer often isn’t the one you’d recommend in real life. 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 about 70% of their portfolio in common stock and 30% in fixed-income securities. Their moderate risk tolerance and growth objective point toward a growth stock or a growth stock fund.
But what if these are the answer choices?
A) Money market fund
B) Revenue bond
C) Convertible bond
D) Short index call
None of the choices looks like a growth stock or growth fund. That’s why elimination is so useful on suitability questions: you remove the clearly unsuitable choices until the best remaining option is obvious.
With that in mind, what’s the best answer?
Answer = C) Convertible bond
Start by eliminating the short index call. Short options are generally used to generate income and can involve significant risk. A short call, in particular, has unlimited risk. Options are also short-term instruments, which makes them a poor match for a long-term retirement growth objective.
Next, eliminate the money market fund. Money market funds emphasize safety and liquidity, so they typically offer low returns and little to no growth potential. They’re most suitable for very conservative investors or short time horizons.
Now consider the revenue bond. Revenue bonds are municipal bonds, which are generally most attractive to investors in high tax brackets. Also, municipal bonds are not suitable for retirement plans. They’re also unlikely to provide meaningful capital appreciation, so they don’t fit a growth objective well.
That leaves the convertible bond. It’s not the ideal recommendation for a 30-year-old seeking growth, but it’s the best of the four choices. The bond component provides income and relative stability, and the conversion feature creates potential for growth if the issuer’s common stock rises. It’s also a longer-term instrument, which fits a retirement time horizon better than options.
On many suitability questions, “the best recommendation” won’t be available. The exam is designed that way. The goal is to see whether you can evaluate the scenario and choose the best answer among the options provided.
Some exam questions include extra numbers or details that you don’t actually need. For example, an options question might include six different numbers, but only two matter for the calculation. In those cases, you’re being tested on your ability to filter out irrelevant information.
Suitability questions work differently. In suitability scenarios, you should assume every detail is there for a reason. Each fact is a breadcrumb meant to steer you toward (or away from) certain answers.
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 see a few suitability questions written in paragraph form like this. The length can feel intimidating, but the question becomes manageable once you track the key facts. Using your notepad can help. For example, you might jot down:
The best answer will be the choice that matches these points most closely.
What would you choose?
Answer = D) Municipal bond fund
Use elimination first. The easiest choice to remove is the Russell 2000 ETF. The Russell 2000 is a small-cap stock index. Buying more stock doesn’t diversify a portfolio that’s already 100% equities.
Next, consider the balanced fund. Balanced funds typically hold a mix of stocks and bonds (often close to 50/50). This investor already has substantial stock exposure and is comfortable with it, so adding a fund that includes a large stock allocation doesn’t address the main goal: adding fixed income for diversification.
That leaves two bond funds. Either would add fixed income and reduce overall portfolio risk, which makes sense for someone nearing retirement with an aggressive (all-stock) allocation.
The deciding factor is taxes. The municipal bond fund is the better choice because the investor’s income is very high. At $650,000 of annual income, the investor is in the highest federal tax bracket (37%), regardless of filing status. Municipal bond interest is generally exempt from federal income tax, so the municipal bond fund is likely to provide a higher after-tax return than the investment grade bond fund, which primarily holds fully taxable corporate bonds.
In that question, every detail mattered:
The North American Securities Administrators Association (NASAA) regulates the securities industry at the state level and is responsible for the exam. The more you understand the regulator’s perspective, the easier it is to predict what the test writers consider “most suitable.”
NASAA’s primary goal is protecting investors from fraud and deceit. The industry has a long history of misconduct, from Bernie Madoff to Jordan Belfort to Elizabeth Holmes. Investor confidence matters; without it, markets don’t function well.
When you work a suitability question, put on a “regulator hat.” Regulators focus heavily on the risk a recommendation exposes a client to. That means:
Here’s how that looks in 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’s the best answer?
Answer = A) Investment grade bond fund
Eliminate the index fund. It’s reasonable to assume this is a stock index fund. The investor is looking for income, and stock index funds typically aren’t designed to maximize income.
Next, eliminate the growth and income fund. It’s still an equity fund (stocks), even if part of the portfolio focuses on dividend-paying companies. The remaining choices are bond funds, which are more directly aligned with an income objective.
Now you’re choosing between two bond funds:
Even though the investor describes themselves as aggressive, the rest of the facts push you toward caution: they’re 70 and living on modest fixed income sources (pension and Social Security). The investment grade bond fund better fits the income need while limiting credit risk, especially given the investor is already maintaining an aggressive equity allocation.
That question illustrates the “err on the side of caution” approach. When two answers could work, the exam often rewards the choice that meets the objective with less risk.