What is an Unsuitable Investment (Unsuitability)?
Let me explain what an unsuitable investment really means. It's when an investment, like a stock or bond, doesn't fit your objectives or financial means as an investor. This could extend to your overall investment strategy too—for instance, if your portfolio's asset mix is off, or if the investments are too aggressive or too conservative for what you actually need or want.
The Duty of Financial Professionals
In most places around the world, financial professionals must take steps to make sure an investment suits you. Here in the United States, the Financial Industry Regulatory Authority (FINRA) enforces these rules. Remember, suitability isn't the same as fiduciary responsibility—it's a different standard.
Key Takeaways
- An unsuitable investment is one that doesn't serve your goals and needs as effectively as it should.
- Financial professionals generally have a duty to offer investments that match your needs.
- Even if they're not bound by fiduciary duty, they're expected to steer clear of unsuitable recommendations.
Understanding an Unsuitable Investment (Unsuitability)
Unsuitable investments aren't the same for everyone in the market. No investment—except obvious scams—is inherently suitable or unsuitable. It all depends on your personal situation, which varies based on your characteristics and goals.
To ensure they're offering suitable options, FINRA rules require investment firms to gather details about you, including your age, other investments, financial situation and needs, tax status, investment objectives, experience, time horizon, liquidity needs, and risk tolerance. You're not obligated to provide this, so there's some leeway if you don't. But having it helps firms avoid pushing unsuitable investments your way.
Take, for example, an 85-year-old widow on a fixed income. Speculative stuff like options, futures, or penny stocks would likely be unsuitable for her because of her low risk tolerance. She's relying on her capital and returns to live, so she and her advisor wouldn't want to risk it all, especially with little time left to recover from losses.
Contrast that with someone in their twenties or thirties. You might be open to more risk since you're still working and don't need the investments for living expenses yet. Higher risk could mean better long-term returns, and your longer horizon gives you time to bounce back from short-term dips. In this case, very low-risk investments might actually be unsuitable for you.
Age isn't the only thing to consider when figuring out unsuitability. Your income, expected future income, financial knowledge, lifestyle, and personal preferences all play a role. Some of you prefer to play it safe, while others are natural risk-takers.
There's a straightforward concept called the sleep test that can help: if you can't sleep at night because of your investments, something's wrong. Adjust the risk until you're comfortable. Then, balance that risk with your other factors to find suitable investments or craft the right strategy.
Fiduciary Responsibility
Don't confuse suitability with fiduciary responsibility—they're different levels of care for clients, with fiduciary being the stricter one. A fee-based investment adviser has a fiduciary duty to find investments and strategies that are truly suitable for you. On the other hand, a commission-based broker—maybe the one you talk to at your broker's call center—typically doesn't have that fiduciary responsibility, but they still need to seek out suitable investments.
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