What is Suitable (Suitability)
A suitable investment meets a firm's, and often legal, criteria that an investment strategy is appropriate for an investor's or client's objectives of risk tolerance and means. In most parts of the world, financial professionals have a duty to take steps that ensure the investment is suitable for a client. For example, in the United States, the Financial Industry Regulatory Authority (FINRA) oversees and enforces these rules. Suitability standards are not the same as fiduciary requirements.
BREAKING DOWN Suitable (Suitability)
Any financial firm or individual dealing with an investor must answer the question "Is this investment appropriate for my client?" Both financial advisors and broker-dealers must fulfill a suitability obligation, which means making recommendations that are consistent with the best interests of the underlying customer. The Financial Industry Regulatory Authority (FINRA) regulates both types of financial entities under standards that require them to make appropriate recommendations to their clients. However, a broker or broker-dealer also works on behalf of the broker-dealer firm.
Following FINRA Rule 2111, which states the customer’s investment profile “includes, but is not limited to, the customer’s age, other investments, financial situation and needs, tax status, investment objectives, investment experience, investment time horizon, liquidity needs [and] risk tolerance,” among other information. A broker’s investment recommendation, based on the facts and circumstances of a particular case, is the triggering event for application of the rule.
No investment, other than outright scams, are inherently suitable or unsuitable for an investor. Suitability depends on the investor's situation based on the FINRA guidelines. To illustrate, for a 95-year-old widow who is living on a fixed income, speculative investments, such as options and futures, penny stocks, etc. are extremely unsuitable. The widow has a low risk tolerance for investments which may lose the principal. On the other hand, an executive with significant net worth and investing experience might be comfortable taking on those speculative investments as part of their portfolio.
Suitability vs. Fiduciary Requirements
People may confuse the terms suitability and fiduciary. Both seek to protect the investor from foreseeable harm or excessive risk. However, the standards of investor care are different. An investment fiduciary is any person who has the legal responsibility for managing someone else's money. Investment advisors, who are usually fee-based, are bound to fiduciary standards. Broker-dealers, customarily compensated by commission, generally have to fulfill only a suitability obligation.
A financial advisor has the responsibility to recommend suitable investments while adhering to the fiduciary standards. The standards require advisors to put their client's interests above their or their firm's interests. For example, the advisor cannot buy securities for their account before recommending or buying them for a client's account. Fiduciary standards also prohibit making trades which may result in the payment of higher commission fees to the advisor or their investment firm.
The advisor must use accurate and complete information and analysis when giving a client investment advice. To avoid conflict of interests, the fiduciary will disclose potential conflicts to the client, and then will place the client's interests before their own. Additionally, the advisor initiates trades under a best execution standard, where they work to execute the transaction at the lowest cost and with the highest efficiency.