Series 6

AAA

Evaluation of Customers - Suitability Factors

Financial Status of Clients
The best way to ensure that your mutual fund recommendations are suitable is to develop a client profile. Be sure to collect the following information at the beginning of your relationship and to update the profile as your client's situation changes over time:

  • Type of client
  • Current status
  • Financial goals
  • Capital and other needs
  • Current investments
  • Risk tolerance
  • Non-financial considerations

Client Type
In addition to individuals and married couples, there are many other potential client types. Because the goals of an organization are likely to be very different from those of an individual, you should be familiar with these other client types:

Partnerships

  • Business partnership - all partners are equally responsible for business debts and share equally in business profits (which pass through to be reported on each partner's personal income tax return).
  • Limited partnership - the general partner is responsible for managing the business and has unlimited liability for its debts, while the limited partners are not responsible for any of the debts.
  • Family limited partnership - this arrangement is used primarily as a means of minimizing estate and gift taxes, but must have a legitimate business purpose (such as managing investment real estate, family business, etc.).

Corporations
The main advantage of all types of corporations is that the owners are not personally liable for the corporation's debts. There are three types:

  • C Corporation - these corporations must pay corporate income tax on their income, and the owners pay personal income taxes on profits received as dividends (known as double taxation).
  • S Corporation - this arrangement is suitable for small companies (less than 75 shareholders) that want the legal protection of a corporation but the flow-through taxation of partnerships (corporate losses are applied to personal income tax return).
  • Limited Liability Corporation - this type of structure allows protection from debts but is taxed more like a sole proprietorship.

Look Out!
You are likely to be given a description of a new business and asked which type of corporation it most resembles. If the question states that losses are expected in the first years, "S Corporation" is the correct answer. If it is a single owner and losses are not mentioned but protection from liabilities is noted, "LLC" is usually the correct answer. (Sole proprietorship is usually the fourth choice.)

Current Status
Before you can begin to help clients meet their goals, you must have a good grasp of their current financial situations. Be sure to inquire about the following information:

  • Income
  • Expenses
  • Assets
  • Liabilities
  • Tax issues
  • Age, marital status, dependents
  • Tax information
  • Participation in retirement and other benefit plans

Capital and Other Needs
The client's specific goals should be discussed in detail. While retirement and college funding are nearly universal, be sure to probe for other goals such as starting a business, helping other family members, or buying a vacation home. A key consideration for any of these goals is the time horizon, which affects both the choice of investment strategy and the amount of annual savings needed to reach the goal. Other needs must be discussed and planned for as well, including:

  • Emergency reserves - while three to six months' living expenses is considered standard, other factors could dictate a larger or smaller need for liquid savings.
  • Life insurance - if the client has a family whose income needs cannot be met through current assets, life insurance is needed. The total amount and type of insurance would depend on client circumstances.

Current Investments
Before making investment recommendations, it's important to understand the client's current holdings and what strategies were used to create them. The client may wish to liquidate some or all of these holdings and reinvest in a new portfolio, or he/she may want to retain all current holdings.

Non-Financial Considerations
A number of non-objective issues can impact what investments and strategies are appropriate for a particular investor, such as:

Investor knowledge and sophistication

  • Client values
  • Client demographics

Risk Tolerance
A primary consideration in recommending suitable investments is an understanding of the client's risk tolerance. If a particular client is uncomfortable with the inherent risk of a growth portfolio or of a specific investment option, it is not suitable - even if it appears to match the client's time horizon and financial goals. Of course, you may try to educate the client as to risk/reward tradeoffs and the history of similar investments, but the client is the final arbiter of how much risk he or she is willing to take.

As indicated in the sections above, the impact of the client's risk tolerance on investment choices will be influenced by:

  • Liquidity needs (short-term and long-term)
  • Inflation or deflation
  • Changes in income level
  • Attitudes toward risk
Investment Objectives
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