When you see suitability questions on the exam, you’ll often be given an investor’s investment objective. This objective describes the investor’s overall goal for their invested capital (money).
Financial professionals use investment objectives to:
You’ll want to know what each objective means in plain language and what types of securities typically match it. The investment objectives covered here are:
If someone wants to invest while taking as little risk as possible, their objective is preservation of capital. This is the least risky objective. It may involve an insured investment (like a certificate of deposit (CD)).
Securities suitable for this objective are generally short-term debt securities with minimal risk exposure. Investors most likely to choose preservation of capital include:
Specific investments suitable for a preservation of capital objective include:
Safety of principal is one step higher on the risk spectrum than preservation of capital. It often leads to large allocations in safe debt securities with longer time horizons.
As a reminder, long-term debt securities have more price volatility. Investors with this objective are usually looking for investments that can provide stable income over long periods of time. Older investors in retirement are most likely to identify safety of principal as their overall investment objective.
Specific investments suitable for a safety of principal objective include:
An objective of tax-advantaged income fits investors who want income that’s taxed at lower rates or is tax-free. In most cases, these investors are:
This objective isn’t limited to short-term or long-term investments, although recommendations often favor longer-term fixed income securities to obtain higher rates of return.
In general, there are two primary investment products that provide tax-advantaged income:
*While dividends from stock are taxed at lower rates (15% or 20%) than interest from bonds (up to 37%), preferred stocks are especially suitable for corporate investors. Corporations are able to deduct at least 50% of the dividends they receive from taxation.
If an income-seeking investor is willing to take on some risk in exchange for moderate levels of income, they have a moderate income objective. The typical investor with this objective is older, but not in a situation where they must be completely risk averse.
For example, a 60-year-old recent retiree with a funded retirement plan may want to replace employment income with fixed income securities that aren’t too safe or too risky.
Specific investments suitable for a moderate income objective include:
Investing in common stock typically involves at least a moderate amount of risk. Investors seeking capital appreciation (buy low, sell high) from common stocks, but without taking on significant risk, tend to have a moderate growth objective (sometimes referred to simply as “growth”).
Younger-to-middle-age investors with long time horizons and no need for current income are most likely to have a moderate growth objective.
Specific investments suitable for a moderate growth objective include:
When an investor is willing to take on significant risk to obtain high yields on fixed income securities, their objective is high yield income. These investors primarily invest in junk bonds, which are rated BB or below by the ratings agencies. In many cases, issuers of these bonds are legitimately at risk of bankruptcy.
Junk bonds typically have two characteristics that lead to high yields:
Preferred stock, especially from distressed issuers, may also be suitable for this objective. Similar to junk bonds, this type of preferred stock tends to have higher dividend rates while trading at discounts.
Investors seeking high-yield income are typically aggressive investors looking for higher returns from fixed-income securities. Elderly and conservative investors usually avoid this objective given the risks involved.
Specific investments suitable for a high yield income objective include:
Growth (capital appreciation) involves buying securities at a low price and selling them later at a higher value. We’ve already covered growth-focused companies, which are businesses focused on increasing revenues through expanded operations.
An aggressive growth objective focuses primarily on smaller companies with high growth potential. For example, what if you invested in Amazon during its IPO in 1997, when it was an online bookstore? Its IPO price was $18 per share, and Amazon later traded above $3,000 a share (as of September 2020). That’s a return of over 16,000%. Amazon’s business model was largely unproven in the late 1990s, but it later became one of the largest companies in the world.
For every Amazon, there are many companies that don’t succeed. In fact, only a third of small businesses survive their first 10 years of business. And survival isn’t the same as profitability - small businesses and start-ups often take several years before they become profitable.
In addition to small businesses, companies from emerging markets can also offer high growth potential. Emerging markets are regions that historically haven’t been major players in the world economy but are becoming more prominent. Countries like Mexico, Thailand, and South Africa are examples. As these economies grow, companies in those regions may grow as well.
Investors in emerging market securities also face risks beyond typical risks (business risk, financial risk, etc.). Many of these regions and countries may have governmental issues (corruption, “red tape,” etc.), economic problems, and weak infrastructure for business.
Certain sector funds are also suitable for aggressive growth. Sector funds invest primarily in stocks of companies from a specific industry. Technology and energy tend to be among the most aggressive sectors, offering higher risk and higher return potential.
An investor with an aggressive growth objective is willing to take chances. Many of the companies or securities they invest in may end in bankruptcy, but the expectation is that the winners (like Amazon) will more than offset the losers. These investments tend to have high betas, meaning their market prices historically have moved faster than the general market.
This objective is only suitable for investors who are very comfortable with risk. Time horizons can be long or short, although it’s generally more prudent to use a long time horizon with risky strategies. If an investment loses significant value, a longer time horizon gives the investor more time to recoup losses.
These investors tend to be young and are not concerned with obtaining income. Remember, growth companies do not generally pay dividends.
Specific investments suitable for an aggressive growth objective include:
Speculation involves investing, but it can resemble gambling because it often depends on short-term market direction, which is highly unpredictable. Speculative investors typically bet on short-term price movements.
Investors seeking this objective are as aggressive and risk-tolerant as it gets:
Speculation is the riskiest investment objective and is only suitable for the most aggressive investors. Younger investors with significant assets are the typical investors who apply this objective to their overall portfolio.
Specific investments suitable for a speculation objective include:
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