What it means
Suitability is a basic rule of investment advice. Before recommending a product, a professional must understand the client's age, income, assets, investment goals, experience and how much loss the client can tolerate.
A recommendation that ignores these facts is unsuitable, even if the product is sound in itself. The same investment can be suitable for one person and unsuitable for another.
A high-growth share fund may suit a young saver with a steady income and decades to invest, while it may be unsuitable for a retiree who needs to draw income from savings next year. The test is the match between the product and the person, not the quality of the product alone.
Typical signs of unsuitable advice include putting too much of a client's money into one risky holding, selling complicated products to inexperienced investors, and recommending frequent trading that mainly generates commission. Another sign is advice that locks up money the client may need soon.
Regulators in most countries have rules on suitability and best interests, and firms have to keep records to prove they followed them. When advice is unsuitable, clients may complain to the firm, an ombudsman or a regulator, and may be able to claim compensation for their losses.
The firm can also face fines and restrictions. For this reason, compliance teams review sales files, and firms use questionnaires to document each client's profile.
The idea applies beyond individual advice. A company treasury should not place surplus cash in volatile investments if the cash is needed for payroll, and a pension trustee should not hold assets that do not match the scheme's liabilities.
In each case the question is whether the choice fits the purpose.
In practice
Real-world examples.
Example
A 68-year-old widow who lives on her savings is sold a complex product that locks up her money for seven years. When she needs funds for care costs, she cannot access them without a large penalty. A complaint to the regulator argues that the product was unsuitable for her needs.
Example
A broker encourages a novice investor to borrow money to buy shares in a single small company. The company falls sharply and the investor loses far more than he can afford. A review finds that the broker never asked about his income or his experience.
Example
A company treasurer places $2,000,000 of the funds needed for a September tax payment in a long-dated fund whose value can swing widely. Internal audit flags it as unsuitable for the purpose, and the treasurer moves the money into short-term deposits.
Formula
Calculation
Concentration % = value of the single holding / total portfolio value x 100
Suppose a retired client has a portfolio of $400,000 and a written policy that no single speculative product should exceed 10% of the portfolio. An adviser puts $120,000 into one speculative product. Concentration = 120,000 / 400,000 = 0.30, or 30%. The policy limit is 400,000 x 10% = $40,000, so the holding is 120,000 - 40,000 = $80,000 over the limit, and a reviewer would likely classify the recommendation as unsuitable.Case study
Seen in the real world.
Oakridge Advisers is an illustrative, fictional firm that recommended a leveraged fund to a client named in its file as cautious. The client, a schoolteacher with $150,000 in savings, put $60,000 into the fund on the adviser's recommendation.
When markets fell, the fund lost 40% of its value, so the client lost 60,000 x 0.40 = $24,000. In the complaint review, the firm could not show any record that it had assessed her tolerance for risk, and its own questionnaire described her as cautious.
The illustrative outcome was that the firm compensated the client and tightened its file reviews. The lesson is that suitability must be documented at the time of advice, not reconstructed afterwards.
Watch out
Common mistakes.
- Believing that a good investment is suitable for everyone, when suitability depends on the individual's needs and circumstances.
- Relying on a client's signature on a risk warning as protection, when the adviser still must show that the recommendation fitted the client.
- Ignoring how the client's circumstances change, so that a product that was suitable at the start becomes unsuitable later.
Questions
People also ask.
Does a client's wish to take risk make a product suitable?
Not automatically, because the adviser must also consider whether the client can afford the loss, and a firm cannot rely only on what the client says they want.
What can a client do about unsuitable advice?
They can complain to the firm, then to the relevant ombudsman or regulator, and may be able to claim compensation for losses.
Does the rule apply to businesses?
Treasury and pension policies apply the same principle, so company funds should be invested in line with the purpose and time horizon of the money.
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