Product summaries

Sidenote

The suitability chapter

One of the most important test topics on the Series 7 is making suitable recommendations. We’ve covered product risks, benefits, and typical investors extensively through previous product-focused chapters. Additionally, we discussed the ethics of operating as a registered representative and market dynamics to be aware of. The aim of this chapter is to provide a “boost” to your suitability skills by reviewing these older topics, while introducing some new concepts and test-taking skills.

Try to approach these sections with a holistic, “big picture” approach. You’ll likely encounter numerous scenario-based suitability questions on the exam that require your knowledge of securities and careful consideration of the client’s needs and goals. While these questions are difficult, they can be answered correctly on a consistent basis when integrating the lessons learned in this chapter.

This summary section provides the most important test points related to the various products we’ve discussed. As always, keeping track of each product’s “BRTI” (benefits, risks, and typical investor) is essential to consistently answering suitability questions correctly.

Common stock

Benefits

• Capital appreciation potential
• Dividend income potential

Systematic risks

• Market risk
• Inflation risk (short-term only)

Non-systematic risks

• Business risk
• Financial risk
• Regulatory risk
• Liquidity risk (for unlisted securities)

Typical investor

• Seeks capital appreciation and/or dividend income
• Younger
• Risk tolerant (moderate to aggressive)
• Long term time horizon

Resources: ‘What is common stock?’ video

Preferred stock

Benefits

• Dividend income
• Capital appreciation if convertible

Risks

• Dividends not guaranteed
• Interest rate risk
• Inflation risk
• Call risk
• Reinvestment risk

Typical investor

• Seeks income
• Accepts moderate risk in return for higher income
• Corporate investors (dividend tax exclusion)
• Long term time horizon

General debt securities

Benefits

• Interest income, which is legally guaranteed

Risks

• Interest rate risk
• Inflation risk
• Default risk
• Liquidity risk
• Legislative risk
• Political risk (foreign debt securities)
• Reinvestment risk
• Call risk

Typical investor

• Seeks income
• Generally older
• Risk averse (conservative)

Corporate debt

Benefits

• Interest income
• Capital gain potential for convertible bonds
• Higher yields (vs. other debt issuers) due to risk
• Variety of choices and risk profiles

Risks

• Interest rate risk
• Inflation risk
• Default risk
• Liquidity risk
• Legislative risk
• Political risk
• Reinvestment risk
• Call risk

Typical investor

• Seeks income
• Generally older
• More risk tolerant (than US gov / muni investors)

Certificates of deposit

Benefits

• Interest income
• FDIC insurance up to $250,000 per bank

Risks

• Low yields in exchange for safety
• Interest rate risk (particularly for long-term brokered CDs)

Typical investor

• Willing to accept low yields in exchange for safety
• Typically older or elderly

Municipal debt

Benefits

• Tax-free interest income for residents
• Typically safe securities

Risks

• Low yields (opportunity cost)
• Interest rate risk
• Inflation risk
• Some default risk (although low)
• High liquidity risk
• Reinvestment risk
• Call risk

Typical investor

• Seeks income
• High income / wealthy
• Willing to accept lower yields in exchange for tax benefits :::

US Government debt

Benefits

• Interest income
• Virtually free of default and liquidity risk
• Generally AAA rated and considered safe

Risks

• Interest rate risk
• Inflation risk (except TIPS)
• Reinvestment risk (except STRIPS)

Typical investor

• Seeks income
• Generally older
• Willing to accept lower yields in exchange for safety

Mortgage backed securities

Benefits

• Monthly income (interest and principal)
• Direct or indirect US government backing
• CMOs offer more predictable outcomes

Risks

• Prepayment risk
• Extension risk
• Interest rate risk
• Reinvestment risk
• Inflation risk

Typical investor

• Seeks consistent (monthly) income
• Generally older
• Comfortable with an unknown maturity date

Investment companies

General suitability

• Instant diversification
• Provides professional management
• Risk depends on the type of fund

Types of funds

Growth funds

• Seeks capital appreciation
• Invests in common stock
• Higher risk potential
• Higher return potential
• Example: American Funds Growth Fund of America

Growth and income funds

• Seeks capital appreciation and income
• Invests in common stock and preferred stock
• Moderate risk potential
• Moderate return potential
• Example: Vanguard Growth and Income Fund

Value funds

• Seeks capital appreciation and income
• Invests in common stock
• Moderate risk potential
• Moderate return potential
• Example: Thrivent Large Cap Value Fund

Balanced funds

• Seeks capital appreciation and income
• Invests in stocks and bonds
• Moderate risk potential
• Moderate return potential
• Example: T Rowe Price Balance Fund

Income funds

• Seeks income
• Invests in stocks and bonds depending on the type of income fund
• Risk and return potential depend on the type of income fund
• Example: JP Morgan Income Fund

High yield bond funds

• Seeks income
• Invests in speculative (junk bonds)
• Moderate to high risk potential
• Moderate to high return potential
• Example: Blackrock High Yield Bond Fund

Conservative bond funds

• Seeks income
• Invests in investment grade bonds
• Low risk potential
• Low return potential
• Example: Fidelity Conservative Bond Fund

MBS agency funds

• Seeks income from mortgages
• Invests in MBS from Ginnie Mae, Fannie Mae, Freddie Mac
• Moderate to low risk potential
• Moderate to low return potential
• Example: PIMCO GNMA and Government Securities Fund

Asset allocation funds

• Various asset mixes
• Asset mix may be static or fluid
• Example: Franklin Moderate Allocation Fund

Life cycle funds

• Type of asset allocation fund
• Asset mix becomes more conservative over time
• Example: State Street Target Retirement 2050 Fund

Money market funds

• Seeks preservation of capital
• Small income potential
• Invests in debt securities with one year or less to maturity
• Very low risk
• Very low return potential
• Example: Charles Schwab Value Advantage Money Fund

Specialized funds

• Invests in securities from specific industries or regions
• Moderate to high risk potential
• Moderate to high return potential
• Example: Morgan Stanley India Investment Fund

Sector funds

• Invests in securities from specific industries
• Moderate to high risk potential
• Moderate to high return potential
• Example: Fidelity Select Pharmaceuticals Portfolio

Real estate investment trusts (REITs)

Suitability

• Equity REITs provide capital appreciation
• Mortgage REITs provide income
• Hybrid REITs provide capital appreciation and income
• Provide real estate diversification
• Unlisted and private REITs subject to liquidity risk
• Real estate may hedge against stock market risk

Hedge funds

Suitability

• High liquidity risk
• High risk and return potential
• Suitable only for wealthy, aggressive investors

Direct participation programs (DPPs)

Suitability

• High liquidity risk
• Tax benefits (losses passed through)
• Moderate to high risk and return potential