Managing others' money can be a difficult task because there is often no guarantee of a positive return when investing in the stock market. However, there are several things that can help an advisor make informed decisions when offering investment recommendations. The financial industry has pushed advisors to adhere to the “know your customer” Financial Industry Regulatory Authority (FINRA) Rule 2111. This rule states that investment advice needs to be suitable for the intended customer, and advisors need a full understanding of the client's investment profile. The rule, which became effective on Oct. 7, 2011, was approved by the Securities & Exchange Committee (SEC) as a way to better regulate investment advisors who may not be serving their clients' best interests.

1. Risk Tolerance

The most important things to understand before investing a client's money are his tolerance for risk and his ability to take a loss. An investor who cannot afford to lose principal should certainly not be invested in stocks or even most fixed-income investments. However, it needs to be conveyed that very little risk to principal means there is very little gain on the upside. Investors who can better handle loss have more potential to generate higher gains over the long term.

2. Time Horizon

Along with risk tolerance, an investment professional should understand the investor’s time horizon. If the money needs to be liquidated in two years, then a long-term bond is not a prudent investment. Time horizon can also correlate to how much risk a person wants to assume. For example, a 20-year time horizon allows the investor's portfolio to have a higher risk profile, knowing that over the long term, investors average out to historic returns of the market. A person who is planning to retire in five years should have a lower risk profile due to having less time for recovery.

3. Preferences and Personality

Client preferences and personality are often overlooked when determining appropriate investments. If a client is relatively new to the world of investing, then complex strategies such as options or derivatives should be avoided. In these scenarios, a new investor should be educated and familiarized with how each investment works. It is imperative that both the advisor and investor understand what is happening in the investment portfolio.

An advisor should also know if his client has any negative opinions about any one industry or company. There are many funds known to be “socially responsible” that avoid investing in alcohol and tobacco companies. Investing in these companies without knowing a client’s opinion could cause issues in the investing relationship.

4. Current Financial Status

Knowing a client’s current financial status also helps an advisor better understand the client's investment profile. A client in a high tax bracket might benefit more by investing in municipal bonds than someone in a low tax bracket. If the money is qualified and held in an IRA or other tax-deferred savings vehicle, this may also be a contributing factor on what types of investments to make.

Understanding the client’s need for liquidity is critical. If the client needs to be able to access the money immediately, this might sway him away from investment vehicles such as annuities or long-term bonds. Withdrawing from these investments early can cause unnecessary surrender penalties or negative pricing.

Figuring the client's total income and net worth also helps complete the investment profile. An investor putting money toward the stock market with nothing in savings is not making a sensible move. The same goes for anyone who has high-interest debt. Being aware of the finances of clients guides the professional into making the correct investment.

5. Investment Goals

Traditionally, most people think of investing as a way to make money or gain interest. Investment goal setting is often overlooked. Providing an advisor with an investment goal helps him better understand what the client is trying to achieve. If a young couple wants to put money away for their newborn’s college fund, then using a 529 college savings plan might be the best choice.

Key Takeaways

Overall, an investment professional needs to know the customer before making any recommendations. The more information provided, the better equipped the professional is to choose the appropriate investments. Not knowing a customer could lead to unsuitable investment advice or loss of principal to the client, as well as legal ramifications for the advisor.

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