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 66 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:
If you can identify these three elements for each investment product, you’ll be able to make consistent suitability decisions on the exam and in practice.
This section focuses on the BRTI of common stock.
Common stock is typically associated with three main benefits:
Capital appreciation (also called growth or a capital gain) occurs when an investment’s value rises above its original purchase price. For example, if you buy a stock at $50 and sell it at $75, you have a $25 capital gain.
Because there’s no ceiling on how high a stock price can rise, common stock has unlimited gain potential. As the market rises, the investor’s potential gain rises as well. For many common stock investors, capital appreciation is the primary source of return.
A gain is unrealized until the investment is sold. Stock prices can fluctuate sharply over short periods. For example, during the early stages of COVID-19 in the United States, the S&P 500 fell 12.5% in March 2020 and then rose 12.6% in April 2020. For context, the S&P 500 averages around a 10% annual return. In other words, the market moved about a “typical year’s” amount in a single month.
The key point is this: an investor must sell the security to lock in the gain. Once the investment is sold, the gain becomes a realized gain. Until then, the gain can disappear if the market declines.
Growth stocks are the most likely to provide capital appreciation. These are stocks of companies focused on increasing revenue, typically at a faster rate than the overall economy. Many companies begin as growth companies while they expand operations and build market share. Companies like McDonald’s, Walmart, and Home Depot were growth companies earlier in their histories, but today they’re large, established firms that are generally beyond their most rapid growth phase.
Some large, well-established companies are still considered growth companies. For example, Amazon is widely known and well-established, but it continues expanding its operations and entering new industries. Amazon has used profits to expand through mass hiring, acquisitions, and ongoing operational improvements.
Amazon has never paid a cash dividend to its stockholders. Cash dividends represent corporate earnings shared with investors. Growth companies often avoid dividends so they can reinvest profits into expansion. If management believes reinvesting earnings will create more value for shareholders than paying dividends, it’s more likely to retain those earnings.
The other way common stock can generate return is income from cash dividends. While growth companies rarely pay dividends, larger, well-established companies that are beyond their rapid growth phase often do. McDonald’s, Walmart, and Home Depot, for example, pay quarterly cash dividends.
Many dividend-paying companies focus on maintaining or gradually increasing market share rather than pursuing major expansion. Consider Walmart: it already has a global presence and generates around $500 billion in annual revenue, which makes it a blue chip company.
Because Walmart isn’t directing as much of its earnings toward aggressive expansion, it can return a meaningful portion of earnings to shareholders. One way to measure this is the dividend payout ratio, which compares annual dividends to annual earnings. Here’s the formula:
Continuing with Walmart, here are its 2019 (fiscal year) figures:
What is Walmart’s dividend payout ratio?
Answer: 40.6%
Value companies are also known for paying cash dividends. If a stock is trading at a “bargain,” it’s often described as a value stock. This is more common among larger, well-established companies. Value companies may pay dividends that are large relative to their stock price.
Some investors build large dividend-paying stock positions and use the dividend income to help cover living expenses. This can be especially relevant for retired investors.
Dividends, however, are not guaranteed. A company can reduce or eliminate dividends at any time, and cuts are more common during economic downturns. Many companies reduced or ended dividend payments during the Great Recession of 2008 and throughout the COVID-19 crisis.
Common stock 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. When older relatives talk about how inexpensive things were “back then,” they’re describing the effects of inflation over time.
Over long periods, the stock market has generally outpaced inflation. As the prices of goods and services rise, stock prices often rise as well - and historically, they’ve tended to rise faster than inflation over the long run. So, if your goal is to protect purchasing power over time, stocks are commonly viewed as one place to invest.
Investment risks are often grouped into two broad categories: systematic and non-systematic. When an event or condition negatively affects the overall market, it’s considered systematic risk. (We’ll cover non-systematic risks later in this chapter.)
Market risk is a type of systematic risk. It occurs when an investment declines in value due to broad market or economic conditions.
The Great Recession of 2008 is a clear example. The S&P 500 - an index of 500 large domestically traded stocks - fell 38% in 2008. A decline of that magnitude suggests that most stocks were falling at the same time.
Even Apple (symbol: AAPL) performed poorly in 2008. Although the first iPhone had been released in 2007, Apple’s stock fell 56%. Put differently, a $1,000 investment on January 1, 2008 would have been worth about $440 at year-end. Apple’s business model was strong, but the stock still declined sharply because the broader economic environment was negative. That’s market risk.
A key suitability point: diversification can’t eliminate market risk. In 2008, even well-diversified portfolios lost significant value. When the overall market declines, it affects most stocks regardless of how many different stocks an investor owns.
We covered the basics of inflation risk (also called purchasing power risk) earlier in this chapter, but it’s worth adding more detail.
Inflation is the gradual rise in prices over time. For example, the median home price in 1950 was around $7,000, but rose to $120,000 50 years later in 2000. This reflects inflation, which tends to occur naturally over time at an average rate of 2-3% annually.
The government measures inflation using 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). On the Series 66 exam, references to CPI are generally references to inflation.
Normal inflation (around 2-3% annually) is generally expected. Higher-than-expected inflation can create economic problems. When prices rise faster than expected (for example, in late 2021-2022), corporations may struggle to maintain profit margins. Inputs and supplies become more expensive, businesses raise prices, and demand may fall. In the short term, higher inflation can pressure common stock prices downward.
Over the long term, the stock market has tended to outpace inflation. Inflation can rise for periods of time, but the Federal Reserve may take action to prevent inflation from becoming too severe. The last time the U.S. experienced sustained high inflation before late 2021/2022 was in the 1980s. Eventually, prices stabilized and the economy recovered.
For exam purposes, market risk and inflation risk are the two major systematic risks to recognize. Market risk is referenced most often, but higher inflation can also affect common stocks - especially in the short term.
Non-systematic risks affect specific companies, industries, or sectors rather than the entire market.
A company faces financial risk when it runs into financial trouble, often because it is over-leveraged (meaning it borrowed too much money). Tesla (symbol: TSLA), for example, faced financial risk for many years. Even if a company’s product is in demand, heavy debt obligations can create serious problems. When financial risk increases, stock prices often decline.
Business risk is related to a company’s ability to operate successfully, but it’s different from financial risk. Instead of focusing on debt levels, business risk focuses on whether the company’s products, services, or strategy are working.
Radio Shack is a good example. Although some stores still exist, Radio Shack’s business peaked in 1999. Over time, it lost customers and revenue to competitors like Best Buy and Amazon and failed to adapt to changes in technology and consumer behavior. Eventually, Radio Shack filed for Chapter 11 bankruptcy in 2015, and again in 2017 after restructuring. When business risk increases, stock value often declines.
Regulatory risk occurs when a company faces challenges due to current or potential government regulation. For example, when Mark Zuckerberg (CEO of Meta (Facebook)) was asked to testify to Congress regarding privacy concerns, Meta faced regulatory risk. If lawmakers impose new rules, the company may need to spend significant money updating policies, training, systems, and business practices. Even if regulation benefits society, it can reduce profitability and put downward pressure on the stock price.
Many common stocks trade on exchanges, such as the New York Stock Exchange. You’ll learn more about the stock market later in this material. For now, assume that exchange-traded stocks generally have active trading and are relatively easy to buy and sell.
Not all publicly traded stocks trade on exchanges. Many smaller or start-up companies trade in the OTC markets. Stocks in the OTC markets often have lower trading volume than exchange-listed stocks. As a result, it may be difficult to sell an OTC stock quickly.
When an investor has trouble converting an investment into cash, they face liquidity risk (also called marketability risk). If there’s little demand for the stock, the investor may have to accept a much lower price to sell.
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 face concentration risk, which amplifies the non-systematic risks discussed above. For example, exposure to financial risk is much greater if an investor owns only one company with high debt levels. In that case, the risk is concentrated and amplified.
For the exam, you’ll need to know the two broad categories (systematic vs. non-systematic) and which risks fall into each category.
Generally speaking, common stock investing is often most suitable for younger investors. Stocks are subject to many risks, and market values can fluctuate sharply. Investors who can’t afford large declines in account value - or who can’t tolerate that volatility - may need to limit stock exposure.
Older investors can (and often should) keep some portion of their portfolio in common stock, but the stock allocation often declines with age. One common guideline is the rule of 100:
For example:
| Age | Stock % | Bond % |
|---|---|---|
| 30 | 70% | 30% |
| 45 | 55% | 45% |
| 60 | 40% | 60% |
| 70 | 30% | 70% |
As age increases, this guideline suggests shifting more money into 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 can change what’s appropriate. For example, it could be suitable for an 80-year-old to hold 80% in stock if they have substantial assets and don’t rely on the portfolio for living expenses. On the other hand, a 20-year-old might only be suitable for 20% in stocks if they’re disabled and living on Social Security. Age is one of many suitability factors.
Time horizon is another reason older investors often reduce stock exposure. In the short term, the stock market can be highly 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 often expect the stock market to rise. Over the past 100 years, there have been many bear markets and major declines. The Market Crash of 1929, the Great Depression, and the Great Recession of 2008 are examples of events that caused severe market declines. Even after large declines, the market has historically recovered and eventually moved beyond prior 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 six months after the fastest decline in history. Recoveries can take months or years, but historically they have occurred.
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 aggressively expanding. Amazon is an example of a growth company.
Other companies, such as McDonald’s, Walmart, and Home Depot, pay quarterly dividends. While these companies may have less growth potential than a company like Amazon, investors can still earn meaningful returns through dividend income over time. Their stock prices may also continue to grow, though often at a slower pace than a high-growth company.
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