Suitability of an investment is one of the legal pillars in the investment industry. The concept of suitability is quite simple: Financial Advisors, Investment companies and their representatives must ensure that the investments they offer, sell or recommend are suitable for the investors who buy them.
The regulators who put suitability standards in place try to protect investors from ‘salespeople’ who are more concerned about selling investments than trying to match appropriate investments with investors. Although the concept may appear to be relatively straight forward, the practice of determining suitability is not perfect.
Regulators set the rules
In Canada, the regulators set the rules around suitability and one of the common practices in the investment industry is something called the Know Your Client (KYC) rules. Basically, all investment firms and professionals must complete a KYC form before they can make investment recommendations.
Know Your Client
Under the know your client rules there are a few key things investment professionals and companies must know before they can recommend investments
- Risk Tolerance. Risk tolerance is simply how much risk the investor is willing to take. The more conservative the investor, the more conservative the investments need to be. Investors should not be investing in high risk investments unless they have some tolerance for risk.
- Time Horizon. Basically, the longer your investment time horizon, the more risk you can accept in a portfolio. The shorter your time horizon, the more conservative your investments should be.
- Investment Objectives. What is your primary investment objective? Is it to grow the portfolio, is it about safety and preserving capital or is it to try to get income from your investments. Your investment objective will in part determine the types of investments you should own. If you are a safe investor looking to preserve capital it may not be suitable or appropriate to own lots of high risk growth investments.
- Investment Knowledge. How knowledgeable are you about investment concepts, information, strategies and ideas? It’s probably inappropriate for investors with very little knowledge to invest in very complex investments like hedge funds and option strategies.
- Financial stability. Theoretically, the more financially stable you are, the better you are to withstand risk in a portfolio.
The other document used to determine suitability of and investment portfolio is something familiar to most investors . . . The risk profile questionnaire. With the risk profile questionnaire, investors are asked to answer 8 to 15 questions and the result matches them to a portfolio that is suitable for their needs.
Suitability is far from perfect
Although I understand the principle behind suitability, there is really are no universal standards of what suitability means.
Having been a financial advisor who has sold product in the past, I know from experience that all of the rules are subject to interpretation and the real problem is that different compliance people can interpret rules differently from office to office, company to company, province to province. What I know for sure is a lot of money, time and resources are allocated to ensuring that suitability is enforced (which may be part of the reason mutual fund fees are so high).
The other problem is how to define some of these overgeneralized terms and standards. For example, when someone uses the term conservative, what does conservative mean? The definition of conservative for a 70 year old may be very different than a 30 year olds definition. What about a 5 year time horizon? That might be long term to some and short term for others?
With all the flaws of the system, the principle of suitability makes sense. It’s all about making sure there is some common sense and prudence put in place in an industry where there are a few bad advisors and institutions that put their selfish interest over the clients.
All investors need to understand that investments should be suitable to their needs and while there are a few documents in the financial industry to determine suitability, investors need to use some common sense and personal judgment as a basic standard.