Suitability refers to the risks and benefits of an investment and is used to determine whether an investment is appropriate for a particular investor. The Series 7 is heavily focused on suitability, with about 73% of the exam testing some aspect of it.
As we cover different investments, it helps to think in terms of the BRTI of each product:
If you can clearly identify these three points for each investment product, you’ll be able to make consistent suitability decisions on the exam and in practice.
Let’s work through the BRTI of common stock.
In general, common stock is more suitable for investors with a longer time horizon. Stocks can involve significant losses, and it may take years for the market to recover. For example, during the Great Recession (2007-2009), many stocks lost 50% or more of their value. Even firms with long histories, such as Bear Stearns, failed.
A major risk of common stock is market risk - the risk that broad market or economic conditions cause stock prices in general to decline. Other investments, such as bonds, also performed poorly during the Great Recession, but the bond market experienced smaller losses than the stock market.
Because recovery can take time, common stock is typically more suitable for younger investors. A younger investor may be able to wait through a downturn and allow time for the market to rebound. An older investor may not have that flexibility and may need to sell investments to generate cash before prices recover.
Even with these risks, stocks are purchased for their return potential. You’ve probably heard the idea that higher risk can come with higher potential return. Investors who experienced large losses during the Great Recession (2007-2009) recovered those losses, on average, by 2012. After that, the stock market grew to all-time highs in 2020. The key point is that stocks can decline sharply in the short term, but they offer significant long-term growth potential.
Common stock can also serve as a hedge against inflation. Inflation is a general rise in prices across the economy, which reduces the purchasing power of the U.S. dollar. When older relatives talk about how inexpensive things were when they were younger, they’re describing the effects of inflation.
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 increase faster than inflation. For example, grocery prices may rise over the next 10 years, but stock values will likely grow more than those price increases. So, if you want protection from rising prices over time, stocks may be one place to consider.
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