4 Basic Pointers When Investing Other People’s Money

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Financial professionals are legally and ethically obligated to follow the Financial Industry Regulatory Authority’s (FINRA) Rule 2111. It mandates that any recommendations must be suitable for the client. To determine what suits each client, you need to consider their unique risk tolerance, personal preferences, finances, and long-term investment goals. You can then create personalized investment strategies that align with their needs and help them achieve their financial goals.

In this article, we detail the four essential aspects of managing other people’s money in compliance with FINRA Rule 2111:

1. Understanding your clients’ investment profiles
2. Conducting reasonable diligence to ensure investments are suitable for at least some investors (reasonable-basis suitability)
3. Determining that recommendations are suitable for each specific customer (customer-specific suitability)
4. Avoiding excessive trading in customer accounts over which you have actual or de facto control (quantitative suitability)

By mastering these four basics, financial advisors can fulfill their legal and ethical duties, create investment strategies tailored to each client, and help them achieve their financial goals while effectively managing risk.

Key Takeaways

• As a financial advisor, managing other people’s money comes with a great deal of ethical and regulatory responsibility.
• You need to understand your client’s investment profile.
• You must have a reasonable basis to ensure investments are suitable for at least some investors.
• You have to determine that it’s not just suitable for some investors but your specific client.
• You must also avoid excessive trading in accounts over which you have control.

1. Understand Your Client’s Investment Profile

As an advisor entrusted with managing other people’s money, it is crucial to thoroughly understand your customer’s investment profile to ensure compliance with FINRA Rule 2111 and create suitable investment strategies. This involves gathering and analyzing information about your client’s circumstances, preferences, and objectives. Here are key parts of every client’s investment profile:

Ability to Handle Risk

You need to understand how much financial volatility your client can handle. There are three related aspects to this:

• Risk Tolerance: This is the client’s emotional and psychological comfort level with the possibility of investment losses. It’s a personal preference shaped by the client’s values, experiences, and financial goals. Someone with a higher risk tolerance might be comfortable with market fluctuations, while someone with a lower risk tolerance prefers stability, even if it means lower potential returns.
• Risk Capacity: This is a client’s financial ability to withstand losses. This is determined by age, income, net worth, and financial obligations. A young investor with a long time horizon and few financial commitments might have a higher risk capacity, while a retiree relying on their portfolio for income would typically have a lower risk capacity.
• Time Horizon: A client with a 20-year time horizon can typically assume more risk, as returns are likely to average out to historical market levels over the long term. However, a client planning to retire in five years should have a lower risk profile to minimize the impact of potential market downturns.

Preferences and Personality

Advisors sometimes overlook client preferences and personality when determining appropriate investments. If a client is relatively new to investing, then you’ll want to avoid complex strategies such as options or derivatives.

You’ll have to educate them about how each investment works so they understand what is happening in the investment portfolio. If they have a lot of knowledge and experience, then you’ll need to figure out how much input your client wants when managing their assets.

An advisor should also know if clients have preferences for where their money is invested, e.g., if they are interested in environmental, social, and governance investing or have other personal leanings beyond the risk-return ratio.

Financial Status

Knowing about your client’s finances is arguably the most important of the four points in this article. Clients in higher tax brackets might benefit more from municipal bonds or tax-deferred savings vehicles, while those in lower brackets might have different priorities.

Understanding the client’s liquidity needs is also crucial, as investments like annuities or long-term bonds may not be suitable for those who need immediate access to their funds due to potential surrender penalties or negative pricing.

Investment Goals

Advisors should know their clients’ objectives when guiding their strategy. For example, a young couple saving for their child’s college education may benefit from a 529 college savings plan. By understanding a client’s goals and needs, advisors can build trust and make necessary adjustments to ensure the investment plan stays on track.

Knowing what a client needs not only builds trust within the relationship but also allows the advisor to recommend changes as circumstances arise.

2. Understanding Reasonable Basis Suitability

The next basic thing to know when investing for others is called reasonable basis suitability. In essence, this says a financial professional must have valid reasons to believe an investment or strategy could be appropriate and beneficial for at least some investors.

It’s not about being right for everyone, so it doesn’t mean every investment has to be a winner or appropriate for every client. Instead, it’s a very low bar that needs to be crossed, namely that you see some merit and benefits that could apply to some investors (though not necessarily your clients).

For example, penny stocks are very risky. Still, there might be a reasonable basis to recommend them to a highly speculative, risk-tolerant investor who understands the potential for total loss.

Important

In 2020, FINRA adopted Regulation BI, amending its Rule 2111 so that “a broker-dealer that meets the best interest standard would necessarily meet the suitability standard.” This means that, beyond the suitability standards for financial advisors discussed below, broker-dealers must also ensure that investments are in the client’s best interest.

3. Understanding Customer-Specific Suitability

As a financial advisor, it’s not enough to recommend investments that are generally suitable for someone; they need to be a reasonable fit for your client. An investment that works for one client might be a poor choice for another.

To ensure your recommendations are a good fit, consider all the data you have on your client’s investment profile: their objectives, comfort with risk, timeline, financial picture, etc. These will help you match them with investments that align with their needs and preferences. Those penny stocks we mentioned earlier? Not likely to cross this bar very often.

4. Understanding Quantitative Suitability

Your responsibilities extend beyond ensuring that individual investments are suitable for your clients. You must also consider the overall impact of your recommendations, especially when you have actual or de facto control over a client’s account. This is where FINRA’s quantitative suitability rule comes into play.

Quantitative suitability requires a reasonable basis for believing that a series of recommended transactions, even if viewed in isolation, are not excessive and unsuitable for the client when taken together. In other words, you must avoid overtrading or churning your clients’ accounts. Red flags include a:

• High turnover rate (frequently buying and selling securities in a client’s account)
• High cost-to-equity ratio (generating commissions that represent a significant percentage of the client’s invested capital)
• In-and-out trading (trading the same security within a short time frame)

To ensure you’re following FINRA regulations, document your rationale for recommending a series of transactions, demonstrating that they are not too much or unsuitable.

How Does a Financial Advisor Measure Risk?

Financial advisors often use questionnaires to measure their client’s risk tolerance. These questionnaires are best when they allow open-ended answers, encouraging the client to share their feelings about losing money.

What Challenges Do Financial Advisors Face?

One of the biggest challenges that financial advisors face is managing client expectations, including returns expectations. Beyond that, other challenges include managing contact with customers.

What Do Clients Want From Their Financial Advisor?

The biggest thing clients want from their financial advisors is someone trustworthy. According to Vanguard, investors are more comfortable with a human touch. As many as 76% of people surveyed said they trusted a financial advisor’s advice while 17% preferred a combination of human and digital advisory services. Only 4% said they trusted a digital advisor or service while 3% said they managed their own finances.

The Bottom Line

When managing other people’s investments, financial advisors must adhere to FINRA Rule 2111, which mandates that recommendations are suitable for each client. To fulfill this obligation, advisors should focus on four key aspects. First, they must understand the client’s investment profile, including their risk tolerance, time horizon, preferences, financial status, liquidity needs, and investment goals. This information is used to create personalized investment strategies that align with the client’s needs and goals.

Advisors must also conduct reasonable diligence to ensure recommended investments are suitable for at least some investors (reasonable-basis suitability) and understand each investment’s risks and potential rewards before recommending it to clients. Third, advisors must determine that recommendations suit each client based on their unique investment profile (customer-specific suitability). Finally, advisors must avoid excessive trading in customer accounts over which they have actual or de facto control (quantitative suitability).

By focusing on these four essential aspects of managing other people’s money, financial advisors can fulfill their legal and ethical obligations, build trust with clients, and help them work toward achieving their financial goals while effectively managing risk.

Read the original article on Investopedia.