STOCKBROKER PROBLEMS
Unsuitability
A broker can only recommend an investment that is suitable for a customer. This requires that the representatives “know their customer”, their goals, their investment objective, and willingness to take risks. The law imposes a duty upon securities brokers only to recommend securities that the broker reasonably believes are suitable for the customer. The broker’s belief must be based upon a reasonable inquiry concerning the customer’s investment objectives, financial situation and needs, tax status, other security holdings, and any other relevant information known by the broker. This suitability duty is based on a “homely truth about investing – that investment decisions can be made only in light of the goals and needs of the person for whom they are made.”
Despite this, unsuitable recommendations of securities are among the most common violations on the brokerage industry. An unsuitable recommendation of securities constitutes a dishonest, unethical and fraudulent business practice. If such a recommendation results in financial loss, the customer has a right to recover that loss.
Broker’s account opening forms typically display investment objective information in a “check in the box” format. Choices include “income,” “growth,” “income and growth” and “speculation.” A portfolio of an investor with an objective of income should contain a substantial allocation to money market, and/or investment-grade short-term fixed income investments. If that investor has a longer time horizon and requires some growth in order to not outlive his or her assets, a substantial allocation to dividend-paying stocks may be appropriate as well. A portfolio compromised substantially of non-dividend-paying growth stocks might be suitable for a younger investor saving for retirement, but not for someone in need of income. A long time horizon may indicate a greater allocation to stocks.
A designation of “speculation” as an investment objective or a level of risk tolerance should be regarded with extreme suspicion. It may be an indicator that the broker intends to use your account as a vehicle to generate excessive commissions. This may be a red flag for unsuitability of the account activity.
A broker cannot have a reasonable basis for recommending an investment or investment strategy without knowing the risk of the particular investment or investment strategy being recommended, and explaining that risk to the customer. A broker cannot know the risk of a particular investment or investment strategy, and properly explain it to the customer, without measuring the risk.
A statistical tool used by financial professionals to measure the risk of a portfolio is called standard deviation. It measures the dispersal of historic returns of an investment of portfolio from the mean return. It is thus a measure of the internal volatility of an investment or portfolio.
In Notice to Members 99-33, the NASD stated that the standard deviation is an appropriate way to measure volatility. Thus, the standard deviation or risk of a portfolio at a given time is not a matter of opinion, but rather a quantitative measurement.
Despite this, Modern Portfolio Theory is often ignored by brokers in making recommendations to customers. While some brokerage firms acknowledge that asset allocation and diversification are keys to successful investing, in our experience, few provide any objective measurement of portfolio risk to their customers.