Quick Answer
A suitability review weighs how a new position changes the composition and diversification of everything a customer already holds, not just the position on its own. Concentration commits a large share of a portfolio to a small number of issues; diversification spreads that commitment across more issues. Firms often cap illiquid or speculative concentration in written policy.
A later unit in this chapter covers specific portfolio risk types, such as purchasing power risk and marketability. This lesson covers composition, diversification, and concentration as inputs to the suitability analysis itself.
Why Does Suitability Look at the Whole Portfolio, Not Just the New Position?
- A suitability review does not stop at testing the new position in isolation. It also weighs how the position changes the composition and diversification of everything the customer already holds.
- A position that looks suitable on its own can still fail the portfolio-level analysis if it duplicates risk the customer's existing portfolio already carries.
- The portfolio view runs the other way too. Regulation Best Interest's adopting release says a recommendation can be in a retail customer's best interest when viewed in the context of that customer's whole portfolio, even where it would not appear to be on its own.
- The release's example is adding what might otherwise look like a risky investment, such as a hedging instrument, to a risk-averse customer's portfolio.
- So the portfolio view can fail a position that passes alone, and it can support a position that looks risky alone.
What Is the Difference Between Concentration and Diversification?
- Concentration: committing a large share of a portfolio to a small number of issues.
- Diversification: spreading that commitment across more issues, reducing the effect any single issue's decline has on the whole portfolio.
- A recommendation that concentrates a customer's holdings in a small number of private placement issues carries more portfolio-level risk than the same dollar amount spread across a diversified set of issues, even when each individual issue is otherwise suitable.
What Other Risk Factors Affect a Concentration Analysis?
- Concentration is not only a matter of counting issues. Several private placements from different issuers can still move together, for example if they share a sponsor, an industry, or a geography.
- A portfolio that looks diversified by issue count can still carry correlated risk for this reason.
- Firms commonly maintain written portfolio-concentration policies capping how much of a customer's account may be committed to illiquid or speculative positions. A recommendation review checks the position against any such firm policy, not only against the customer's own profile.
Exam Tip: Gotchas
- Issue count alone does not prove diversification. Five private placements sponsored by the same real estate operator can behave like one concentrated position if that operator's business runs into trouble.
What Should You Check on Exam Day?
- Test a new position against the customer's existing portfolio, not only against the customer's profile in isolation. The portfolio view can fail a position that passes alone, and it can support one that looks risky alone.
- Look past issue count for a shared sponsor, industry, or geography that could make issues move together.
- Check a recommendation against any written firm concentration policy in addition to the customer's own investment profile.