Investment Suitability

The suitability of an investment for a particular person is at the very heart of the investment process. This is a fundamental concept both from a legal perspective and in terms of putting an investor's money to work sensibly and prudently. When money is invested unsuitably, there is a high probability of unacceptable losses (or equally negative, very low returns) and considerable distress for the investor. FINRA Rule 2111 governs general suitability obligations.

Here we'll take a look at the concept of suitability from a broker's/advisor's perspective.

What Is a Suitable Investment?

A suitable investment is defined as one that is appropriate in terms of an investor's willingness and ability (personal circumstances) to take on a certain level of risk. Both of these criteria must be met. If an investment is to be suitable, it is not enough to state that an investor is risk-friendly. They must also be in a financial position to take certain chances. It is also necessary to understand the nature of the risks and the possible consequences.

Asset Allocation and Risk Profile

Why is suitability such an issue? The main problem is that investors often do not understand what risk entails, while brokers might be tempted to advise people toward riskier investments. Further complicating the matter is the fact that excessively low-risk investments can be just as damaging to an investor's portfolio as those that carry unsuitable levels of risk. Therefore, suitability demands investments that are neither too risk-friendly nor too risk-averse for a particular investor.

According to FINRA regulations, a broker must have a reasonable basis for believing that an investment meets a client's needs and objectives. Unfortunately, suitability is not always entirely clear cut. While there can be no doubt that even a risk-friendly investor should not put 100% of their total assets into the stock market, when the percentage drops to, say, 60% or lower, the issue becomes less clear. If an investor owns some real estate and has a conservative pension plan, the 80% and 60% figures take on a different perspective compared to someone with no other assets. Considering the age and other aspects of the client's personal and financial situation is also crucial.

Another way of looking at suitability is that it refers to investments that are just not right for someone. For example, it is unlikely that someone on the brink of retirement would have their entire account tied up in the futures market. However, the same person may be able to have 50% of their portfolio in conventional equities, although this may be too risky for someone about to retire, at which time a portfolio of about 25% equities is generally considered more suitable.

Suitability largely boils down to asset allocation. Both the law and good investment practices prohibit anybody being advised into an asset allocation that does not make sense for that particular person at that particular time. An investor's portfolio must be appropriately diversified so as to generate a reasonable level of returns at a reasonable level of risk.

Suitability is constantly in flux. As indicated above, what is suitable for someone who is 30 years old is very different from what that person will need when they are 60. Getting married, having children, getting a big raise, or losing a job altogether should prompt a reconsideration of suitability. As usual, this boils down to risk and liquidity. If someone will need their money soon, it may not be able to be tied up in stocks or other longer-term investments. For those who want to get the best out of their money over the long run, something like government bonds might be suitable.

Understanding Trading Risks

For investors, knowledge, and understanding also play a role in suitability. This does not mean that just because an investor understands the risks associated with futures that this investment is suitable. However, investors should have an understanding of the risks of the securities in their portfolios.

If an investor doesn't understand a more complicated investment vehicle, such as a structured product, for example, something more straightforward, such as a mutual fund, may be more suitable. From a selling perspective, what makes something unsuitable in the context of investor understanding is selling an investor an asset that they would not otherwise buy. This can be viewed as an abuse of the investor's lack of understanding. And, if there are perfectly good alternatives with which an investor is more familiar and comfortable with, there may not be any reason to take on more sophisticated instruments.

Unsuitable Investments and the Law

What does the law have to say about unsuitable investments? If an investor goes into an investment purely on their own initiative (known as execution-only) and no one has advised the person to do so, there isn't much the law can do.

On the other hand, if a broker or bank advises an investor into an unsuitable investment, that financial professional could be liable for the investor's losses, provided the person can prove the investment was unsuitable and that the broker or advisor did not make the risks clear. As a result, in some cases, cautious brokers will only sell really high-risk and potentially unsuitable investments if buyers sign a document stating that they are aware of the risks associated with these investments.

Of course, firms generally have litigation insurance, so they can afford to fight claims of unsuitability in court. However, if investors can produce clear documentation of risk aversion and that an obviously high-risk investment cost them dearly, they do stand a chance in court. But for investors, litigation remains a rocky road, which is often no less costly than the unsuitable investments themselves.

The Bottom Line 

No one should ever have investments that are not appropriate for their personal circumstances and willingness to take risks. At the extreme, truly unsuitable investments can ruin a portfolio, but even lesser cases can cause a lot of stress for investors. Nothing in the investment process is more important than allocating assets correctly. Furthermore, the process of ensuring suitability needs to be monitored regularly by both investors and advisors.