Customer Profile and Investment Objectives Flashcards
All the following components make up the requirements for FINRA’s suitability obligation rule, except:
A
Quantitative suitability
B
Reasonable-basis suitability
C
Qualitative suitability
D
Customer-specific suitability
C
Qualitative suitability
To comply with reasonable-basis suitability, the RR must make sure the security is suitable for some investors. The RR must have a reasonable basis to make the recommendation to the customer. This is the reasonable-basis obligation to a customer. Regarding the customer-specific obligation, the RR needs to make sure that the security is suitable for a specific investor, based on their specific investment goals. Even though a single activity does not define how one would violate the quantitative-suitability obligation, we do know that if an RR were to do excessive trading it would violate the quantitative obligation. Qualitative obligation is NOT defined under the suitability obligation regulation.
A client recently took a good look at the statements showing their previous year’s investment results. They earned almost the same amount this year as last year but can buy less this year than last year. What type of risk best explains their predicament?
A
Capital risk
B
Reinvestment risk
C
Inflationary risk
D
Market risk
C
Inflationary risk
When the price of goods and services grow at a faster pace than an investor’s portfolio, the investor will not be able to buy as much this year as they could last year. The risk that this could happen is known as inflation (or purchasing-power) risk. Investors in fixed-income securities (bonds) and fixed annuities will have a great deal of purchasing-power risk. Traditionally, investments in gold and equities are good choices to combat inflation risk. On the flip side, the kinds of fixed-income securities that are susceptible to purchasing-power risk do not have large amounts of capital risk, while equities and gold put the investor’s capital at risk. Investing is all about risk/reward.
Which of the following mutual funds would be subject to the greatest amount of business risk?
A
Municipal bond fund
B
GNMA fund
C
U.S. government bond fund
D
Corporate bond fund
D
Corporate bond fund
The corporate bond fund invests in bonds issued by corporations that operate for-profit businesses which would be subject to business risk. The municipal bond fund invests in a portfolio of municipal bonds of state and local governments, so there is little business risk. The GNMA fund invests in a pool of GNMA pass-through certificates, again with very little business risk. U.S. government bond funds invest in securities issued by the U.S. government, such as T-bill, T-notes, and T-bonds. The only answer choice subject to a large amount of business risk is the corporate bond fund. Remember, all mutual funds issue common shares. Therefore, all mutual funds have at least some level of business risk.
What type of risk is primarily associated with fixed-income securities, creating an inverse relationship between interest rates and security pricing?
A
Marketability risk
B
Bond risk
C
Purchasing-power risk
D
Interest-rate risk
D
Interest-rate risk
Interest-rate risk is the risk that an investment’s value will change inversely to changes in the general economy’s interest rates (as interest rates rise, bond prices fall and vice versa). Interest-rate risk affects the value of bonds more directly than stocks, and it is a major risk to all bondholders. As a fixed-income security, preferred stocks are also subject to interest-rate risk.
A 31-year old dentist is a renowned risk taker who does not plan to marry and wants to maximize the growth in their portfolio so that they can retire as early as possible. Which of the following funds should be the focal point of their mutual fund portfolio?
A
An aggressive growth fund
B
A progressive growth fund
C
A growth and income fund
D
A growth fund
A
An aggressive growth fund
Of the funds listed, the one that provides this investor with the best chance of retiring early (or not retiring at all, but that’s how risk and reward interact) is the aggressive growth fund. A progressive growth fund does not exist.
The risk of a bond being called when interest rates decline is known as:
A
Market risk
B
Purchasing-power risk
C
Interest-rate risk
D
Call risk
D
Call risk
Callable bonds are called (refunded) when interest rates fall. The bond investor will have to reinvest proceeds into another bond with a lower coupon. Purchasing-power risk is also called inflation risk. Interest-rate risk is the risk that an investment’s value will change inversely to changes in the general economy’s interest rates and is a major risk to all bondholders.
A client has $100,000 to invest and is looking for recommendations. The client has recently moved into a nursing home, which is covered under a long-term care insurance policy. This client has current income, including Social Security and pension income covering most of the client’s monthly expenses. This client wishes to supplement their monthly income with the least amount of risk. Which of the following is the most suitable recommendation for this situation?
A
Large-cap fund
B
Value fund
C
Corporate bond fund
D
U.S. Treasury fund
D
U.S. Treasury fund
The U.S. Treasury fund invests in T-bills, T-notes, and T-bonds and is virtually default free. This fund offers safety and preservation of capital while generating income. The corporate bond fund would generate income, but it is not as safe as the Treasury fund. The large-cap fund will typically seek growth with some dividend income but, again, does not meet the client’s risk tolerance. The value fund seeks capital appreciation, not income, so it would not meet the objective nor the risk tolerance and is the least appropriate of the answer choices.
Which of the following is not considered financial information?
A
Income
B
Value of current assets
C
Investment objectives
D
Current insurance coverage
C
Investment objectives
Financial information quantifies the investor’s present financial condition. Investment objectives define the investor’s financial goals for the future.
While a single recommendation may be suitable for a customer, many similar recommendations might not be, depending on the customer’s objectives, needs, and ability to pay for the recommended transactions. This is known as:
A
Quantitative suitability
B
Qualitative suitability
C
Reasonable-basis suitability
D
Customer-specific suitability
A
Quantitative suitability
Quantitative suitability states that firms must have a reasonable basis to believe the number or size of recommended transactions within a certain period is not excessive, considering the size and character of the customer’s account.
Which of the following best describes the origin of discretionary income?
A
Income derived from interest and dividends
B
Buildup of cash value in a life insurance policy
C
Assets are greater than liabilities
D
Monthly income is greater than monthly expenses
D
Monthly income is greater than monthly expenses
Discretionary income is the money left over after an investor has paid all their monthly expenses out of their monthly income. This is a potential source of investment funds.
A highly risk-averse investor has decided to put all their money into Treasury bonds. These bonds pay a fixed interest rate of 2% annually. The investor is content with this decision, even though the interest rate is exceptionally low, because of the government guarantee. The investor intends to hold the bonds until maturity, using the interest payments to help meet living expenses. While it is true that Treasury bonds are free from default risk, what is this investor’s major risk exposure now?
A
Purchasing-power risk
B
Reinvestment risk
C
Credit risk
D
Interest-rate risk
A
Purchasing-power risk
Also called inflation risk, this is the risk that the rate of inflation will erode the value of the bonds if they are held until the maturity date. For example, if the investor purchased a 20-year Treasury bond at its $1,000 par value, the investor would receive their principal returned in 20 years. But 20 years from now, $1,000 will not buy as many things as it does today. At a 2% interest rate, it is quite likely that the interest payments will not keep pace with the rate of inflation. While the investor will not lose money in nominal terms, there is a loss of purchasing power, and they will fall behind in inflation-adjusted terms. Like all bondholders, this investor is subject to interest-rate risk. This is the risk that if interest rates rise, the market price of bonds will fall, and the investor might not be able to sell them for as much as they paid. However, this is not a primary risk as the investor intends to hold the bonds until maturity, and the principal is government guaranteed. Reinvestment risk is also not a primary concern, as the investor intends to use the interest payments to live on and will not reinvest them. Therefore, the investor is not concerned about interest rates falling and would otherwise not be able to reinvest the interest payments at the same rate that had been earned previously. Credit risk is another term for default risk, and Treasury bonds are virtually default-risk free.
Relevant Content: Customer Profile and Investment Objectives
A customer, age 65, has just retired and is looking to supplement their current monthly income, which they receive from Social Security and a small pension. The customer has $150,000 in total various CDs and money market accounts but is unhappy with the current rates being offered. The customer has limited investment experience because the customer has always been concerned with losing money. This individual is very conservative and is not concerned with inflation. Which product is most suitable for this individual?
A
Corporate bond fund
B
GNMA bond fund
C
Equity income fund
D
Variable annuity
B
GNMA bond fund
With GNMA bond funds, safety and income are key. The fund invests in mortgage-backed securities backed by the federal government. The variable annuity can provide lifetime payments, but variable annuities are a more aggressive choice for investors. The client clearly stated there is no concern regarding inflation and there is a low risk tolerance, so a variable annuity is not suitable. Corporate bond funds invest in corporate debt instruments and have a higher risk (and higher return) than government or municipal bond funds. Equity income funds derive income primarily in the form of dividends, typically from preferred stock and large-cap companies. The most suitable choice for this customer is the GNMA bond fund.
An investor is considering 2 different investments. One investment choice, Treasury-Inflation Protected Securities (TIPS), are guaranteed by the U.S. government. The other investment choice is an investment grade corporate bond. Which risks are common to both investment choices?
A
Taxability risk and currency risk
B
Credit risk and market risk
C
Interest-rate risk and market risk
D
Inflation risk and credit risk
C
Interest-rate risk and market risk
Interest-rate risk is the risk that an investment’s value will change inversely to changes in the general economy’s interest rates (as interest rates rise, bond prices fall and vice versa). Interest-rate risk affects the value of bonds and preferred stock more directly than common stock, and it is a major risk to all bondholders. All bonds are subject to interest-rate risk, even if the bonds are insured or U.S. government guaranteed. Market risk (systematic risk) is the possibility that the value of an investment will fall due to a decline in the market as a whole and is unrelated to any adverse conditions of an issuer. Systematic risk is inherent to investing in the market.
A recently married couple with no investment experience wishes to invest the $3,327 in cash they received in wedding gifts. Considering the couple has no additional liquid assets, what investment option is the best recommendation?
A
Invest the entire amount in an index fund to provide broad market exposure at a reasonable cost
B
Invest 50% in a growth fund and 50% in a high-grade corporate bond fund
C
Keep the funds liquid (in the bank) to meet emergencies that may arise in the future
D
Invest all the funds in a U. S. government bond fund for maximum safety
C
Keep the funds liquid (in the bank) to meet emergencies that may arise in the future
There are many theories on how much cash individuals should have on reserve before they choose to expose their assets to risk. In most cases 3-6 months of gross income is recommended. The young couple clearly needs to avoid capital risk with the wedding gifts they received. When they amass greater assets, they can begin looking to longer-term investing.
A client is saving money to take a cruise with their former college roommates in 8 months. The client is looking to invest their vacation savings in hopes to generate double digit returns over the next 8 months. Which of the following investments should be recommended?
A
Money market fund
B
Junk bonds
C
Call options
D
Aggressive growth fund
A
Money market fund
The client’s investment horizon is too short for an aggressive investment. It should be recommended to invest conservatively, scale back the expectations, and protect this vacation nest egg.
