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." ¹

Despite this, unsuitable recommendations of securities are among the most common violations in the brokerage industry. "Perhaps the clearest example of a suitability violation occurs where a broker recommends speculative securities to a customer whose financial situation clearly calls for conservative investments (for example, a retired person who needs the income from his investments for his living expenses and who has no reasonable expectation of being able to replace any substantial trading losses)."²

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 from the individual broker and his or her brokerage firm.

Broadly speaking, there are three benchmarks for determining whether an investment or investment portfolio is suitable: (1) investment objective(s), (2) time horizon, and (3) risk tolerance. Brokerage firms' account opening forms typically display investment objective(s) information in a "check the box" format. These forms are usually completed by the broker, purportedly based on information from the customer. Typical choices include "asset preservation" or "income," "growth," and (sometimes) "speculation."

Most experts agree that the overall portfolio of an investor with an objective of asset preservation and/or 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 comprised 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 from investments. A longer time horizon militates in favor of a greater allocation to stocks, and vice versa.

A designation of "speculation" as an investment objective or a level of risk tolerance should be regarded with extreme suspicion. Based on our experience, it is an indicator that the broker intends to use your account solely as a vehicle to generate excessive commissions. You should communicate your true investment objectives and risk tolerance in writing to the compliance officer of your brokerage firm.

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The development, over the past 50 years or so, of a quantitative approach to investment analysis based upon statistical models, is broadly referred to as Modern Portfolio Theory, or MPT. Among the most basic and important precepts that have arisen out of MPT, and have come to be understood and widely accepted in the academic and financial communities, are the following: (1) that asset allocation - i.e., the mix of asset classes, such as stocks, bonds, and cash - within a portfolio is responsible for about 92% of the variability in portfolio performance over time, while the particular securities within each asset class are responsible for only about 5%; (2) that proper asset allocation and diversification allow an investor simultaneously to reduce risk and maximize the return for any given level of risk; (3) that an optimum asset allocation and diversification can be objectively determined for any desired level of risk; and (4) that the risk (standard deviation) of a portfolio can be objectively measured.

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 or portfolio from the mean return. It is thus a measure of the internal volatility of an investment or portfolio.³

In Notice to Members 99-33⁴, the NASD stated that the standard deviation is an appropriate way to measure volatility, as follows:

Firms have considered a variety of parameters in identifying the stocks that will be subject to increased maintenance margin requirements. A particularly useful approach is to calculate the volatility of the stock and impose more stringent requirements on stocks that are highly volatile. In this context, one appropriate way to measure volatility is to calculate the standard deviation of the relative daily return of a given stock over a specified time period, such as three months (which would capture an entire quarterly earnings cycle).

See NASD Notice to Members 99-33. 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, MPT is largely ignored by securities 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.

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¹ NORMAN POSER, BROKER DEALER REGULATION ss 3.03 (3d ed. 2005) (quoting Robert Mundheim, Professional Responsibilities of Broker-Dealers: The Suitability Doctrine. 1965 Duke L.J. 445, 448).
² NORMAN POSER, BROKER DEALER REGULATION ss 3.03 (3d ed. 2005).
³ By contrast, beta compares the volatility of an investment to a known benchmark, for example to the S&P 500 Index.
⁴ NASD NTM 99-33 was issued to advise members about maintenance margin requirements for certain volatile stocks.