Advisors who manage others' money must adhere to the Financial Industry Regulatory Authority's (FINRA) Rule 2111 for suitability. The rule made effective on October 7, 2011, legally requires advisors to serve their clients' best interests. To comply with the rule and determine suitability, advisors must consider a client's risk tolerance, preferences and personality, financial status and investment goals.
1. Risk Tolerance
Advisors know it is vital to understand a client's risk tolerance ability. In other words, their ability to take a loss. For example, it may not be appropriate for an investor who cannot afford to lose principal to invest in stocks or even most fixed-income investments. However, investors who can better handle loss have more potential to generate higher gains over the long term.
Time horizon can also correlate to how much risk a client should assume. For example, a client with a 20-year time horizon can have a higher risk profile since over the long-term, returns will likely average out to historic market returns. A client who is planning to retire in five years should have a lower risk profile since they have less time to recover from a down market.
2. Preferences and Personality
Advisors often overlook client preferences and personality when determining appropriate investments. If a client is relatively new to investing, then avoid complex strategies such as options or derivatives. They must educate a new investor about how each investment works so they understand what is happening in the investment portfolio.
An advisor should also know if a client has any negative opinions about any one industry or company. For instance, investing in alcohol or tobacco companies without knowing a client’s opinion could cause issues in the investing relationship. Investigating funds that are “socially responsible" if the client requests is a good way to show you understand them beyond their financial goals.
3. Current Financial Status
Knowing a client’s current financial status is arguably the most important of the four points in this article. A client in a high tax bracket might benefit more by investing in municipal bonds or tax-deferred savings vehicles than someone in a low tax bracket. Understanding the client’s liquidity needs are critical. If the client needs to be able to access the money immediately, an advisor might steer clear of investment vehicles such as annuities or long-term bonds since withdrawing from these investments early can cause surrender penalties or negative pricing.
4. Investment Goals
Traditionally, most people think of investing as a way to make money or earn interest but overlook investment goal setting. Providing a client with an investment goal helps him better understand what he is trying to achieve. For example, an advisor who knows that a young couple has a goal of paying for a child's college education may suggest a 529 college savings plan.
Knowing what a client needs not only builds trust within the relationship, but it better allows the advisor to make changes to their clients profile along the way to ensure the plan stays the course.
Overall, an investment professional needs to understand the client before making investment recommendations. The more information gathered, the better equipped the advisor is to choose the appropriate investments. Not knowing a client could lead to unsuitable investment advice or loss of principal to the client, as well as a potential violation of FINRA Rule 2111.