Elements of Portfolio Management: Recognizing Potential Unsuitability Claims

By David Newfield

The most common claim customers make against their brokers in FINRA arbitrations are unsuitability claims. Under FINRA Rule 2111, a broker has a duty to make sure any recommended transaction is suitable for the customer. Many factors contribute to an assessment of suitability for a portfolio. FINRA issued guidance on the specifics of Rule 2111 in Regulatory Notice 12-25. The notice explains the three main suitability obligations of the rule. These obligations are reasonable-basis suitability, customer-specific suitability, and quantitative suitability.

Customer-specific suitability requires the broker to consider a specific investment, or investment strategy, in the context of a particular customer. The customer’s age, experience, and risk tolerance are a few of the factors a broker must consider. Many brokers fail to consider customer-specific suitability. Therefore, it is important for a customer to be aware of the basic elements of portfolio management, in order to recognize when his or her broker may have behaved improperly.

Traditional portfolio management theory seeks to find an optimal balance of assets in order to effectively manage risk while still seeking maximum return. Most portfolios are made up of a balance of fixed income and equities. Deciding how to balance these elements will depend on the specific needs of the customer. Three useful factors to look at are age, asset, and allocation.

1)     Age: When investing, the age of an investor is one of the first questions to ask. As people age, their needs and investment goals change. Someone starting to invest for retirement may be interested in growth, and have a higher risk profile; whereas somebody already retired will be interest in safe, income-producing, investments. (Tip: A common trick many people use to calculate an ideal stock-bond balance is to invest the same percentage in bonds as a person’s age. Thus, a 25 year-old should invest 75% of his or her portfolio in stock.)

2)     Asset: Not all stocks and bonds are created equal. Although some stocks or bonds may offer a higher return, this comes along with greater risk. It is important for an investor to consider both the asset class as well as the specific asset. (Tip: When choosing stocks, consider the size, style, and sector of the stocks.)

3)     Allocation: Everybody knows the age-old adage: Don’t put all your eggs in one basket. It is important for every portfolio to be appropriately diversified. An investor should consider if his or her investments appear to be too concentrated. (Tip: Try to invest in a handful of companies that you know, trust, or even use in your day to day life.)

Although this list is not exhaustive, an investor can begin to gain insight in to his or her portfolio by considering age, asset, and allocation. Furthermore, FINRA Rule 2090 requires brokers to “know your customer.” A broker has an obligation, when opening and maintaining an account, to know the essential facts concerning every customer. It should raise a red flag to an investor if he or she feels that his or her broker has not inquired about his or her background and investment goals.