The new Series 7 top-off exam places more emphasis than ever on the concept of suitability. Candidates who take this exam are likely to see as many as 20-25 suitability questions that require analysis of a set of facts and an appropriate recommendation based on a unique customer situation. If you’re preparing for the Series 7, you might think these are some of the most difficult questions, but with practice and the right approach, they become manageable.

The two questions below are typical. See how you fare, and then read the suitability question tips that follow.

Sample Suitability Questions

1) Your customer, age 40, is asking your advice on investment options for her recent bonus. She has consistently saved money in her 401(k) plan at work, and has a good start on college savings in 529 college savings plans for her two children. She would like this investment to increase her retirement savings. She is willing to take some risk in exchange for strong appreciation. Which of the following investment choices will you recommend to this client?

  1. High-grade corporate bond fund
  2. Preferred stock ETF
  3. Mid-cap stock fund
  4. REIT

Explanation: The best choice for this customer is C, a mid-cap stock fund. Because the investor is seeking growth (appreciation) for a long-term objective (retirement), stock is essential. She has indicated willingness to take some risk, so a mid-cap stock fund is appropriate. A preferred stock ETF is more suitable for an income objective because of preferred stock’s fixed dividends. High-grade bond funds and REITs (real estate investment trusts) are also appropriate for income objectives.

2) You are meeting with a couple who plans to retire within the next two years, and they are asking you to identify the appropriate mix of assets for their investment portfolio. They have substantial savings in retirement plans from work, have paid off their mortgage, and have minimal credit card debt. Which of the following portfolios is most appropriate for them?

  1. 50% stocks, 25% bonds, 25% cash
  2. 60% stocks, 30% bonds, 10% options
  3. 40% bonds, 30% equities, 30% cash
  4. 60% bonds, 30% stocks, 10% money market securities

Explanation: The best choice for this couple is D, which is structured to meet the income needs of retirement age with its heavier weighting toward bonds, but also includes some stock to provide an inflation hedge. It’s always a good idea for a couple in or near retirement to establish an emergency fund, which should be equal to about three to six months of living expenses. Because money market funds are highly liquid, they are a great choice for emergency funds. Leaving a high percentage of cash, like 25% or 30%, as in choices A and C, is generally not appropriate because the cash will lose purchasing power with inflation.

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Five Key Factors to Look for in a Suitability Question

If you need help understanding the “why” in the questions above, see below for some important tips.

A suitability question usually tells a story and provides a number of facts about a customer, some relevant, some there for distraction. These questions can be a paragraph or two in length. Your first job in attacking a question like this is to be sure you read the full question and don’t ignore any of the information provided in your rush to get to the finish. A best practice is to read the question all the way through, read all four answer choices, and then read the question one more time.

As you’re reading the question, pay close attention to these five key suitability factors.

  1. Investor objective
  2. Investor age
  3. Investor income level
  4. Investor time horizon
  5. Investor preference or experience

The guidance below will help you choose appropriate investments based on these five factors.

Factor One: Investor Objective

The investor objective generally falls into the category of growth, income, or capital preservation. However, the question doesn’t always call this out clearly. You need to interpret the story. Here are some things to remember:

  • An investor saving for the future or wanting capital appreciation has a growth objective. It’s important to ensure that the investment keeps pace with inflation, so a growth objective generally aligns with a common stock recommendation. Aggressive growth points toward stocks in technology companies, start-ups, small-cap companies, or companies with high price/earnings ratios. Conservative growth indicates stock in well-established, blue chip, or large-cap companies that have a strong performance history.
  • An investor seeking income or wanting to supplement current earnings needs an investment that provides a steady payout. Fixed-income products like bonds are usually the best choice, but preferred stock is also viable because of its fixed dividend. A common stock investment, even with a high dividend payout, is usually not the best answer here, because dividends are not guaranteed. However, if common stock is the only choice, look for a utility stock that historically pays a high consistent dividend. REITs are also appropriate for providing income, especially if the investor is looking for an investment that isn’t highly correlated to stock market performance.
  • An investor who doesn’t want to lose money or fears loss of principal has a capital preservation objective. The safest of all investments are US Treasury securities, so these would be the first choice. But if the investment need is only for a very short period, money market securities may be appropriate because they historically retain their NAV of $1.00 per share, but with a very low return.

Factor Two: Investor Age

The age of the investor helps identify the appropriate portfolio mix. Younger persons need more growth to keep pace with inflation over a long investment period; older investors need to be more conservative because they don’t have time to earn back investment losses. A rule of thumb might help you in these scenarios. Subtract the age of the investor from 100. The result is the approximate amount of equity that should comprise the investor’s portfolio. For example, a 30-year-old investor should have about 70% of his or her portfolio in equity; an 80-year-old about 20%. Remember, this not a hard-and-fast rule, but it gives some guidance when you’re dealing with questions that ask you to choose the right portfolio mix.

Factor Three: Investor Income Level

The income level of the investor is especially important when determining whether municipals bonds are appropriate for income objectives. Remember, munis should only be recommended for persons with a high income level (more than $100,000 for a single investor is a good rule of thumb), and never within retirement accounts. Income also impacts whether alternative investments may be appropriate. For example, high-income investors might benefit from a DPP (direct participation program) investment, or options positions, or other “unique” investments for a percentage of their portfolios. There should never be a high concentration, however, so keep the percentage in these alternative investments at no more than about 10%-20% of the total portfolio.

Factor Four: Investor Time Horizon

The time horizon of the investor helps further refine the appropriate choice. A long-term investment horizon is likely to be more greatly impacted by inflation, so stocks are important in the overall picture. If income is needed over a long time frame, a bond ladder might be a good recommendation to smooth interest rate risk. If money is needed within a short time frame, or if the customer needs a high degree of liquidity, a money market account is a good place to park funds and avoid loss of principal.

Factor Five: Investor Preference or Experience

An investor’s preference or bias for or against a particular investment is always important in the recommendation, so don’t ignore these clues. Maybe the investor had a bad experience with a limited partnership in the past. In that case, a DPP probably isn’t appropriate. If the investor has an income need but prefers an equity portfolio, preferred stock is probably best. Finally, if the investor wants to maximize income but has high risk tolerance, a high-yield bond fund may work well.

Keep Practicing

Suitability questions will get easier as you practice them. You’ll learn to sift through and find the relevant details if you focus on the five key suitability factors discussed previously. It’s also important that you have good knowledge of investment product characteristics so you can match them appropriately with investor needs and wants.

For more information, check out the resources found in the Training Center at www.Knopman.com, including the new Suitability Exam.  Keep working through practice questions, and you’ll be well on your way to a passing Series 7 score.

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Written by Marcia Larson
Marcia Larson is Vice President, Faculty, at Knopman Marks Financial Training, New York, NY. She has extensive experience in financial licensing and regulatory training, having authored, developed and presented courseware for numerous securities and insurance exam preparation and continuing education and compliance programs. Before joining Knopman Marks, Marcia was Director of Annuity Products and Business Development at CUNA Mutual Group, where she developed and marketed industry-leading annuity products and retirement solutions and implemented distribution relationships. She was previously VP, Securities Products for Kaplan Financial, managing securities training products and subsequently, international training and businesses development. Marcia has trained thousands of financial industry exam candidates throughout their careers, and also college students as an adjunct professor. Marcia was a summa cum laude graduate of Wartburg College with degrees in Business Administration and Piano Performance. Marcia also holds the designations of Chartered Financial Consultant® (ChFC®), Chartered Life Underwriter (CLU®), Certified Employee Benefit Specialist (CEBS), and Fellow Life Management Institute™ (FLMI®). She currently teaches the SIE, Series 6, 7, 24, 50, 52, 63, 65, and 66 exams.