Client Recommendations & Portfolio Management - Series 66

Suitability Standards Under the Uniform Securities Act

Suitability is a fundamental obligation for both broker-dealers and investment advisers under the Uniform Securities Act and state regulations. The suitability requirement mandates that before making a recommendation to a client, a financial professional must have reasonable grounds to believe that the recommendation is suitable for the client based on the client's investment profile.

Under the USA and NASAA model rules, it is unlawful for a broker-dealer, agent, investment adviser, or investment adviser representative to recommend a security or investment strategy unless there is reasonable basis to believe it is suitable. This prohibition applies to all recommendations, whether solicited or unsolicited by the client, and whether or not the client ultimately follows the recommendation.

Suitability: The requirement that a recommendation must be appropriate for a client based on reasonable investigation of the client's financial situation, tax status, investment objectives, risk tolerance, time horizon, liquidity needs, and other relevant financial information. Suitability ensures that recommendations align with clients' best interests and capabilities.

The Three-Part Suitability Framework

Modern suitability obligations consist of three interrelated components, derived from FINRA and industry best practices, which are also applicable under state law:

Reasonable-basis suitability: The adviser or agent must have a reasonable basis to believe that the recommendation is suitable for at least some investors. This requires understanding the security's characteristics, risks, rewards, and costs. If the professional does not understand the product, they cannot recommend it to anyone.
Customer-specific suitability: The professional must have reasonable grounds to believe that the recommendation is suitable for the specific customer based on that customer's investment profile. This is the core suitability obligation and requires thorough knowledge of the client's individual circumstances.
Quantitative suitability: Even if individual transactions are suitable, the professional must ensure that the overall pattern or frequency of transactions is not excessive or unsuitable given the client's profile. This addresses churning and excessive trading concerns.

A common exam question tests whether suitability applies to unsolicited transactions. Remember: if the client initiates an unsolicited purchase (the client calls and says "buy me 100 shares of XYZ"), the agent may execute the trade without performing suitability analysis. However, if the agent makes ANY recommendation (even in response to a client inquiry), suitability obligations apply. The key is whether a recommendation was made.

Suitability for Investment Advisers vs. Broker-Dealers

While both investment advisers and broker-dealers face suitability obligations, investment advisers are held to a higher standard due to their fiduciary duty. The Investment Advisers Act of 1940 and state law impose a fiduciary obligation on investment advisers requiring them to act in the client's best interest at all times, placing the client's interests ahead of their own.

Under the fiduciary standard, an investment adviser must:

Provide advice that is in the client's best interest, not merely suitable
Seek best execution for client transactions
Disclose all material conflicts of interest
Avoid misleading statements or omissions
Provide ongoing monitoring and supervision of client accounts

Broker-dealers and their agents, by contrast, are subject to a suitability standard that requires recommendations be appropriate for the client but does not require that every recommendation be the absolute best available option. However, as of 2026, Regulation Best Interest (Reg BI) has enhanced broker-dealer obligations to include a best-interest standard when making recommendations to retail customers, narrowing the gap between broker-dealer and adviser obligations.

Know Your Customer (KYC) Obligations

The "Know Your Customer" rule is the foundation of suitability. Before making any recommendations, a financial professional must make a diligent effort to obtain and maintain accurate, current information about the client. The KYC obligation is not a one-time event but an ongoing responsibility that requires periodic updates as client circumstances change.

Essential Client Information

At a minimum, financial professionals must obtain and document the following client information:

Financial situation: Income, net worth (assets minus liabilities), liquid net worth, cash flow, debt obligations, employment status, and anticipated future financial needs (college funding, home purchase, retirement).
Tax status: Current marginal tax bracket (federal and state), whether income is earned or passive, tax filing status, and exposure to alternative minimum tax (AMT). Tax considerations significantly impact investment recommendations.
Investment objectives: The client's goals for the account or portfolio, such as capital preservation, income generation, capital appreciation, growth, speculation, or a combination of objectives.
Risk tolerance: The client's willingness and ability to accept investment losses. This includes both psychological comfort with risk and financial capacity to absorb losses without jeopardizing essential goals.
Time horizon: The expected duration before funds will be needed. Short-term horizons (under 3 years) generally require more conservative investments, while long-term horizons (over 10 years) can accommodate higher-risk, higher-growth investments.
Liquidity needs: The extent to which the client requires access to invested funds on short notice. Clients with high liquidity needs should avoid illiquid investments like limited partnerships, private placements, or real estate.
Investment experience and knowledge: The client's sophistication and familiarity with different investment types. Less experienced clients require simpler, more transparent investments.
Other relevant factors: Age, health, dependents, existing holdings, estate planning considerations, ethical or social investment preferences, and concentrated stock positions requiring diversification.

If a client refuses to provide essential information or provides incomplete information, the agent or adviser must not make recommendations in the absence of sufficient data. Making recommendations without adequate client information violates suitability obligations and can result in regulatory sanctions. The professional should document the client's refusal and limit the account to unsolicited transactions only.

Updating Client Information

Client circumstances change over time due to life events such as marriage, divorce, birth of children, job changes, inheritance, health issues, or approaching retirement. Financial professionals must establish procedures to update client information regularly. Best practices include:

Conducting formal client reviews at least annually
Requesting updated financial information when significant life events occur
Sending annual questionnaires to clients to confirm or update their profiles
Documenting all client communications that reveal changes in circumstances
Adjusting recommendations and portfolio holdings when client profiles change

A 35-year-old client with a stable job, high income, and 30-year time horizon has an aggressive investment objective and high risk tolerance. The client's portfolio is allocated 90% to equities. Ten years later, the client is now 45, recently divorced, supporting two children, facing higher living expenses, and planning to retire in 15 years. The adviser must update the client's profile, reassess risk tolerance, likely reduce the equity allocation, and shift toward a more balanced portfolio reflecting the client's changed circumstances and shorter time horizon.

Risk Tolerance Assessment

Risk tolerance is one of the most critical components of the client profile. It determines the appropriate asset allocation, investment selection, and portfolio construction. Risk tolerance has two dimensions that must be evaluated separately: willingness to take risk (psychological/emotional capacity) and ability to take risk (financial capacity).

Willingness vs. Ability to Take Risk

Willingness to take risk refers to the client's psychological comfort with market volatility and potential losses. Some clients are comfortable watching their portfolio decline 20% in a market downturn, while others panic and sell at the worst possible time. Willingness is subjective and varies based on personality, experience, and emotional factors.

Ability to take risk refers to the client's financial capacity to absorb losses without jeopardizing essential financial goals. A client may be emotionally comfortable with high risk but lack the financial resources to sustain significant losses. Conversely, a wealthy client may be financially able to take risk but psychologically averse to it.

When willingness and ability conflict, the adviser must recommend a portfolio aligned with the more conservative of the two. If a client has high willingness but low ability (e.g., emotionally aggressive but financially constrained), the portfolio must be conservative. If a client has low willingness but high ability (e.g., emotionally conservative but financially wealthy), the portfolio should still be conservative because the client will likely react poorly to losses.

Risk Profile	Typical Asset Allocation	Investment Focus	Example Investments
Conservative	20-40% stocks, 60-80% bonds/cash	Capital preservation, income	T-bills, investment-grade bonds, large-cap dividend stocks
Moderate	50-60% stocks, 40-50% bonds/cash	Balanced growth and income	Balanced funds, blue-chip stocks, corporate bonds
Aggressive	80-100% stocks, 0-20% bonds/cash	Capital appreciation, growth	Small-cap stocks, growth stocks, sector funds, international equity
Speculative	100% high-risk equities/alternatives	Maximum growth, speculation	Options, commodities, emerging markets, leveraged ETFs

Factors Affecting Risk Tolerance

Several factors influence a client's appropriate risk tolerance:

Age and time horizon: Younger clients with longer time horizons can generally tolerate higher risk because they have time to recover from market downturns. Older clients nearing retirement have shorter time horizons and lower risk capacity.
Financial resources: Clients with substantial liquid assets relative to their needs can afford to take more risk because losses will not materially impact their lifestyle. Clients with limited resources must be more conservative.
Income stability: Clients with stable, secure income (tenured professors, government employees) can take more portfolio risk than clients with volatile income (commissioned salespeople, business owners).
Liquidity needs: Clients who may need to access funds on short notice must maintain conservative, liquid holdings. Clients with no near-term liquidity needs can invest in illiquid or volatile assets.
Investment experience: Experienced investors who have lived through market cycles may be more comfortable with volatility than inexperienced investors who panic during the first market decline.

Risk tolerance is not static. It changes as clients age, as their financial circumstances evolve, and as they experience market volatility. A client who was aggressive at age 30 may become moderate at age 50 and conservative at age 65. Regular reassessment of risk tolerance is essential to maintaining suitable portfolios. The Series 66 exam frequently tests scenarios where client circumstances change, requiring portfolio adjustments.

Portfolio Recommendations and Asset Allocation

Once the client profile is established, the adviser or agent must construct or recommend a portfolio that aligns with the client's objectives, risk tolerance, time horizon, and other relevant factors. Asset allocation—the division of the portfolio among major asset classes such as stocks, bonds, and cash—is the most important determinant of portfolio performance and risk.

Investment Objectives and Strategies

Common investment objectives and their corresponding strategies include:

Capital preservation: The primary goal is to avoid loss of principal. Suitable investments include money market funds, Treasury bills, short-term investment-grade bonds, and FDIC-insured bank deposits. This objective is typical for clients nearing or in retirement with low risk tolerance.
Current income: The goal is to generate regular cash flow from interest or dividends. Suitable investments include dividend-paying stocks, investment-grade corporate bonds, preferred stocks, REITs, and bond funds. This objective is common for retirees or clients needing portfolio income to supplement other income sources.
Growth and income (balanced): The goal is to achieve moderate capital appreciation while generating some income. A balanced portfolio typically allocates 50-60% to equities and 40-50% to fixed income. This objective suits moderate-risk clients seeking both growth and stability.
Growth (capital appreciation): The primary goal is long-term appreciation of principal with little or no current income. Growth portfolios are heavily weighted toward equities (70-90%), particularly growth stocks, small-cap stocks, and international equities. This objective suits younger clients with long time horizons and higher risk tolerance.
Aggressive growth (speculation): The goal is maximum capital appreciation, accepting substantial risk and volatility. Aggressive portfolios may be 100% equities, including small-cap stocks, emerging markets, sector funds, leveraged investments, and derivatives. This objective is suitable only for sophisticated clients with high risk tolerance and substantial financial resources who can afford significant losses.

Strategic Asset Allocation

Strategic asset allocation establishes long-term target allocations to major asset classes based on the client's profile. The strategic allocation serves as the portfolio's baseline and reflects the client's risk-return tradeoff. For example, a moderate-risk client might have a strategic allocation of 60% stocks, 35% bonds, and 5% cash equivalents.

Strategic allocation is based on several principles:

Diversification: Spreading investments across multiple asset classes, sectors, and geographic regions reduces portfolio risk without necessarily sacrificing expected return.
Long-term focus: Strategic allocation is designed for long-term holding periods (5+ years) and is not adjusted based on short-term market movements or forecasts.
Rebalancing: Periodically selling outperforming asset classes and buying underperforming ones to restore the target allocation. Rebalancing is a disciplined, contrarian strategy that maintains the desired risk level.

Tactical Asset Allocation

Tactical asset allocation involves making short-term deviations from the strategic allocation to capitalize on market opportunities or avoid perceived risks. For example, if an adviser believes stocks are temporarily overvalued, they might reduce the equity allocation from 60% to 50% for several months.

Tactical allocation is an active management strategy requiring market timing judgments. It is appropriate only when the adviser has demonstrated expertise, the client understands and approves the approach, and deviations are bounded by preset limits (typically plus or minus 10-15% from strategic targets).

The Series 66 exam often contrasts strategic and tactical allocation. Remember: strategic allocation is passive, long-term, and based on the client's profile. It changes only when the client's circumstances change. Tactical allocation is active, short-term, and based on market forecasts. It involves temporary deviations from the strategic allocation to exploit perceived opportunities. Most clients are best served by strategic allocation with periodic rebalancing.

Modern Portfolio Theory and Diversification

Modern Portfolio Theory (MPT), developed by Harry Markowitz, demonstrates that diversification can reduce portfolio risk without sacrificing expected return. The key insight is that combining assets with low or negative correlation produces a portfolio with lower volatility than any single asset alone.

Effective diversification requires spreading investments across:

Asset classes: Stocks, bonds, real estate, commodities, cash
Sectors and industries: Technology, healthcare, financials, consumer goods, energy
Geographic regions: U.S., developed international markets, emerging markets
Investment styles: Value vs. growth, large-cap vs. small-cap
Security types: Individual stocks and bonds vs. mutual funds and ETFs

Research suggests that a portfolio of 20-30 individual stocks across various sectors eliminates most unsystematic (diversifiable) risk—the risk specific to individual companies. However, systematic (market) risk—the risk affecting all securities—cannot be diversified away and represents the primary source of portfolio risk in well-diversified portfolios.

Deep Dive Correlation and Portfolio Risk

Correlation measures the degree to which two assets' returns move together. The correlation coefficient ranges from +1.0 (perfect positive correlation) to -1.0 (perfect negative correlation):

+1.0: Assets move perfectly in sync. No diversification benefit.
+0.5 to +0.8: Positive correlation but not perfect. Typical for stocks in related industries. Moderate diversification benefit.
0: No correlation. Assets move independently. Significant diversification benefit.
-0.5 to -1.0: Negative correlation. Assets move in opposite directions. Maximum diversification benefit.

In practice, most stocks have positive correlations ranging from +0.3 to +0.7, while stocks and bonds often have low or slightly negative correlations (-0.2 to +0.2). This is why a portfolio of 60% stocks and 40% bonds typically has lower volatility than a portfolio of 100% stocks, even though the all-stock portfolio might have higher expected returns. The diversification benefit comes from the low correlation between stocks and bonds—when stocks decline, bonds often rise or hold steady, cushioning portfolio losses.

Documentation and Recordkeeping Requirements

Comprehensive documentation is essential to demonstrate compliance with suitability obligations and protect against regulatory scrutiny or client disputes. Both state law and federal regulations impose strict recordkeeping requirements on broker-dealers and investment advisers.

Required Documentation

Financial professionals must create and maintain records documenting:

Client profile information: New account forms, financial questionnaires, investment policy statements, and risk tolerance assessments. These documents establish the factual basis for suitability determinations.
Recommendations and advice: Documentation of all recommendations made to clients, including the rationale, supporting analysis, and client's response. For investment advisers, this may include written investment plans or portfolio proposals.
Communications with clients: Meeting notes, telephone call logs, emails, and correspondence discussing investment strategies, performance, or changes to the client's circumstances.
Transaction records: Trade confirmations, account statements, and records of all securities purchases and sales. These demonstrate execution of recommendations and portfolio changes.
Account reviews: Documentation of periodic account reviews, including dates reviewed, findings, and any recommendations for portfolio adjustments.
Supervisory reviews: Records of supervisory review and approval of accounts, recommendations, and transactions, demonstrating compliance oversight.
Disclosures: Copies of all disclosures provided to clients, including Form ADV Part 2 (brochure) for investment advisers, fee schedules, conflict of interest disclosures, and risk disclosures.
Advisory contracts: For investment advisers, signed copies of all advisory agreements, including fee arrangements, services to be provided, and termination provisions.

Retention Periods

Under the Investment Advisers Act of 1940 and the USA, investment advisers must retain most records for at least five years, with records from the most recent two years maintained in an easily accessible place (typically the adviser's office). Broker-dealers are subject to similar retention requirements under SEC Rule 17a-4, generally requiring retention of most records for three to six years.

Failure to maintain adequate records is a serious violation that can result in regulatory sanctions even if no other wrongdoing occurred. Regulators presume that if records are missing or inadequate, violations occurred. The best defense against regulatory action or client complaints is thorough, contemporaneous documentation of all client interactions, recommendations, and the reasoning behind them.

Investment Policy Statements (IPS)

An Investment Policy Statement is a written document that formalizes the client's investment objectives, constraints, and the strategy to be employed in managing the portfolio. While not legally required for all advisory relationships, an IPS is considered a best practice and provides clear evidence of the client's understanding and agreement with the investment approach.

A comprehensive IPS includes:

Client objectives: Return requirements, income needs, and specific financial goals (retirement funding, estate planning, college savings).
Risk tolerance: Quantified measures of acceptable volatility and maximum tolerable loss.
Constraints: Time horizon, liquidity requirements, tax considerations, legal or regulatory restrictions, and unique client circumstances (ethical investing preferences, concentrated stock positions).
Strategic asset allocation: Target allocations to major asset classes with acceptable ranges for each (e.g., equities: 55-65%, fixed income: 30-40%, cash: 5-10%).
Performance benchmarks: Indices or blended benchmarks against which portfolio performance will be measured.
Rebalancing policy: Triggers and procedures for restoring the portfolio to target allocations.
Review schedule: Frequency of portfolio reviews and circumstances requiring interim reviews.

IPS Scenario: A 52-year-old client plans to retire at 65 with $1.2 million in investable assets. She needs portfolio growth to maintain purchasing power but cannot tolerate significant losses. Her IPS specifies: (1) Objective: Growth with capital preservation; target 6% annual return. (2) Risk tolerance: Moderate; maximum acceptable loss in any year is 15%. (3) Time horizon: 13 years to retirement, then 25+ years in retirement. (4) Asset allocation: 60% equities, 35% fixed income, 5% cash, with rebalancing when any class deviates by more than 5% from target. (5) Benchmark: 60% S&P 500, 35% Bloomberg Aggregate Bond Index, 5% 90-day T-bills.

Remember the key components of Know Your Customer with "FORTE-L": Financial situation, Objectives (investment goals), Risk tolerance, Time horizon, Experience and knowledge, Liquidity needs. These six factors form the foundation of every suitability determination and must be documented for each client.

Check Your Understanding

Test your knowledge of client recommendations and portfolio management. Select the best answer for each question.

1. An agent receives a call from a client who says, "Buy me 500 shares of XYZ stock right now." The agent has never discussed this stock with the client. What is the agent's suitability obligation?

For truly unsolicited trades where the client initiates the specific transaction without any recommendation from the agent, the agent may execute the trade without performing suitability analysis. However, the agent must document that the transaction was unsolicited. If the agent had made any recommendation about XYZ stock (even in the past), suitability obligations would apply.

2. A client has high emotional comfort with risk (high willingness) but limited financial resources (low ability to take risk). What investment approach is most appropriate?

When willingness and ability to take risk conflict, the adviser must recommend the more conservative approach. A client with limited financial resources cannot afford significant losses regardless of their emotional comfort with risk. If substantial losses occurred, the client would be unable to recover financially, making aggressive investments unsuitable despite the client's high risk tolerance preference.

3. Which of the following is NOT a required component of Know Your Customer obligations?

Political affiliations and voting history are not relevant to suitability determinations and are not required KYC information. The essential elements are financial situation, investment objectives, risk tolerance, time horizon, liquidity needs, tax status, and investment experience. While some clients may have ethical or social investment preferences (e.g., ESG investing), political affiliation itself is not a standard KYC component.

4. An investment adviser establishes a 60% stock / 40% bond target allocation for a client based on the client's moderate risk tolerance and 15-year time horizon. This is an example of:

Strategic asset allocation establishes long-term target allocations to major asset classes based on the client's investment profile. The 60/40 allocation serves as the portfolio's baseline and will be maintained through periodic rebalancing. Strategic allocation is a passive, long-term approach that changes only when the client's circumstances change, not in response to market forecasts.

5. Under the Investment Advisers Act, investment advisers must generally retain most books and records for at least:

6. A 28-year-old client with stable employment, no dependents, and a 35-year time horizon wants to invest for retirement. She can tolerate significant short-term volatility. Which investment objective is most suitable?

The client's young age, long time horizon (35 years to retirement), stable employment, no dependents, and high risk tolerance all point toward an aggressive growth objective with heavy equity allocation (80-100% stocks). The long time horizon allows the client to recover from market downturns, and the lack of near-term liquidity needs means the portfolio can remain fully invested in growth-oriented assets. Capital preservation and current income are inappropriate for someone 35 years from retirement.

7. The primary benefit of diversification across asset classes with low correlation is:

Diversification reduces portfolio risk (volatility) without necessarily reducing expected returns by combining assets that do not move in perfect lockstep. This is the fundamental insight of Modern Portfolio Theory. However, diversification cannot eliminate all risk—systematic (market) risk remains. Diversification does not guarantee positive returns or increase expected returns; rather, it provides a more favorable risk-return tradeoff.

8. A client refuses to provide information about their net worth and income, stating it is private. What should the agent or adviser do?

If a client refuses to provide essential financial information, the agent or adviser cannot fulfill their suitability obligations and must not make recommendations. The appropriate course is to document the client's refusal and limit the account to unsolicited transactions only. Making recommendations without adequate information violates suitability obligations and exposes the professional to regulatory sanctions and civil liability.