Unsuitability / Unsuitable Investments
Unsuitability / Unsuitable Investments
Investment professionals are under an obligation to have a reasonable basis for believing a particular investment strategy or transaction is suitable for their clients. The Financial Industry Regulatory Authority (FINRA) requires brokerage firms and other investment professionals to take steps to ensure a client makes a suitable investment. It holds investment firms liable for unsuitable investments made by their clients.
What Are Unsuitable Investments?
If investments don’t meet the means and objectives of the investor, they become unsuitable investments. This could be the result of an unsuitable investment strategy, such as a wrong asset mix, a too-aggressive purchase of investments, or an investment that is too low-risk compared to the needs of your client.
However, no investment is inherently unsuitable, unless it’s an outright scam. Suitability varies between market participants and may depend on each investor’s situation, characteristics, and goals. What may be unsuitable for one investor may be suitable for another. Brokerage firms and other investment professionals need to assess each prospective investor to determine the suitability of their investments.
But FINRA is in place to guide investment professionals on how to determine the suitability of any investment, depending on the potential investor. The regulatory body requires investment firms to collect critical information about each investor to avoid offering unsuitable investments to them. For example, penny stocks, options, futures, and other speculative investments may be unsuitable for a 90-year-old widow living on a fixed income. Her advanced age may not allow her enough time to recoup should she experience losses.
What Makes an Investment Suitable?
It may not be easy to determine unsuitable investments without the knowledge of what makes an investment suitable. FINRA sets out three important components underlining suitability obligations:
You’ll need information on the customer’s financial situation, investment experience and objectives, and risk tolerance before you can recommend a certain security to your client. Here are some helpful illustrations:
- A retired client relying on their brokerage account for income will not be suitable for investments whose cost may be too high or too high risk. If they make such investments, they may never recover in the event of massive losses.
- An investment too illiquid will not be suitable for clients who may need to access their funds when emergencies strike.
- Investors with little experience may want to steer clear of non-traded RETS and leveraged ETFs, which require clients with lots of experience in the investment field.
You have reasonable suitability if the client can assess and evaluate the risks associated with the investment, or can allow the broker to do it on their behalf. If you don’t understand the investment, it makes sense not to recommend it. If you recommend them, and they become unsuitable investments, FINRA may take legal action against you.
FINRA 2111 also needs investment professionals to recommend investments that are quantitatively suitable. The number of securities transactions should be managed by the investor because they attract fees. If the transactions are too many, they’ll make it difficult for your client to profit, and may lead to unsuitable investments.
Too many transactions in a client account denotes churning or excessive trading. Some brokers may engage in this practice to generate more commissions for themselves, but leave the client high and dry. A responsible broker advises their clients on the number of transactions that can keep their investments profitable, avoiding unsuitable investments.
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Determining Unsuitable Investments vs. Suitable
Every investment broker has a legal duty to prevent their clients from making unsuitable investments. As a broker, you need to stay on the right side of the law by learning how to determine the suitability of an investment proposition by a client.
This information should help you:
- Financial situation: Ask questions about their liquid net worth and annual income.
- Liquidity needs: Find out if the client will need to cash out their investments without incurring loss of value.
- Risk tolerance: How much is the client willing to lose part or all of their investments for greater potential gains?
- Investment time horizon: How much time do they need to achieve their financial goals? Find out if the client has enough time to recoup in case of losses.
- Investment experience: Certain investments require experience. If the client is new to the investment field, consider starting small.
- Age: Younger clients have more time and flexibility on their hands compared to older people.
- Other factors include tax status, investment objectives, and other investments in the client’s portfolio.
Need More Information on Unsuitable Investments?
If you need to learn more about unsuitable investments, and how to establish suitability, feel free to contact us today.