What is an Unsuitable Investment?
Or is it more appropriate to ask, what is a suitable investment? A suitable investment is one that is consistent with an investor’s objectives and/or risk tolerance, among other factors, in the context of the investor’s life circumstances. An unsuitable investment, on the other hand, is one that is inconsistent with either one’s investment objectives or risk tolerance, or is otherwise inconsistent with a specific investor’s needs or circumstances. For example, if an investor’s objective is income, and the investor is either unwilling or unable to place principal at risk, an obviously unsuitable investment would be a non-investment grade bond. Non-investment grade bonds are often referred to as junk bonds. Equally inappropriate are investment grade bonds that are not part of a diversified portfolio. For example, in today’s yield hungry environment, many investors have concentrated their portfolios in lower end investment grade bonds from a single sector. Bonds issued by different governmental or quasi-governmental entities in Puerto Rico provide a prime example. Many Puerto Rico bonds managed until early 2014 to maintain investment grade ratings. However, their extraordinarily high yields made them attractive to income seeking investors. The logic was simple, but naïve – if the bonds are investment grade, why shouldn’t an income investor simply load up? What can possibly go wrong? Well, lots can go wrong. Those high yields, by necessity, equate to higher risk. Investors are easily mislead by so called investment grade ratings, when in reality they and their advisors should be taught to understand that higher yield only comes in exchange for higher risk, notwithstanding third party ratings.
In a December 2013 Regulatory Notice, the Financial Industry Regulatory Authority stated,
Rule 2111, FINRA’s suitability rule, requires that a broker-dealer and its associated persons have a reasonable basis to believe that a recommended transaction or investment strategy involving a security is suitable for the customer. A firm and its registered representatives, in making a recommendation, must consider the customer’s investment profile, including the customer’s age, other investments, financial situation and needs, tax status, investment objectives, investment experience, investment time horizon, liquidity needs, risk tolerance, and any other information the customer may disclose to the broker-dealer or registered representative in connection with the recommendation.
In the same Regulatory Notice, FINRA explains that before recommending an investment, a broker must be able to demonstrate both “reasonable basis suitability” and “customer-specific suitability”. Reasonable basis suitability means that the broker must perform reasonable diligence to understand the nature of the recommended security in order to determine whether the investment is suitable for some investors. In other words, if the investment has rocket science complexity, the broker must be able to understand it completely in order to know whether it makes sense for anyone. Customer-specific suitability means that a broker must have a reasonable basis to believe that a recommendation of a security or strategy is suitable for the particular customer based on the customer’s investment profile.