Risk-tolerance assessment is a critical part of the know-your-client (KYC) process, yet surprisingly in Canada and most other jurisdictions, there are no standards in place for how a risk-tolerance assessment is to be conducted. This has created a gap that needs to be addressed without delay; not just to protect investors, but also to assist investment professionals in discharging their duties.
Currently, dealers and individual advisors employ widely varying practices for assessing risk tolerance. Many simply perform vague and highly subjective evaluations based solely on the advisor’s “feel” after discussions with the client. Others rely on “scores” derived from answers to written questionnaires that assign numerical values to the responses and map the resulting tallies to asset allocations or model portfolios.
However, according to Geoff Davey of Australia-based FinaMetrica Pty Ltd., which has developed a renowned risk-profiling system, the scoring typically is rudimentary and arbitrary due to inappropriate weighting of the risk factors isolated in the questionnaires. Moreover, there may be no objective basis for concluding that the questionnaire’s design will elicit valid information about the client’s true willingness and ability to take financial risks.
Added to this is the problem that risk is a somewhat mercurial concept: it means different things to different people; it can be highly contextual; and it’s very difficult to quantify. (This is increasingly evident from comments filed in response to the Canadian Securities Administrators’ proposed risk classification methodology for use in Fund Facts documents).
These difficulties point all the more to a need for an effective and uniform practice standard. Without one, inadequate risk-tolerance assessment methods create the hazard that clients and advisors may be on different pages when they discuss risk. The resulting misalignment of understanding invariably compromises the advisor’s ability to make suitable recommendations, endangering investors even where their advisors are completely well-intentioned.
Fortunately, the basic outlines of a viable standard are beginning to take shape. Davey, for example, maintains that a complete risk profile should include more than just an evaluation of how much risk a client prefers to take (risk tolerance). It also must assess how much risk they can afford to take (risk capacity or loss capacity) and how much risk is necessary to achieve the client’s investment objectives (so-called “required” risk).
Then, advisors need to identify any mismatches between these three measures and help the client make trade-off decisions to determine the appropriate asset allocation and risk level to apply to his or her portfolio. In some cases, a mismatch may indicate that the client’s investment objectives are, themselves, unsuitable or unrealistic.
The U.K.’s Financial Conduct Authority (previously known as the Financial Services Authority [FSA]) has expressly endorsed this approach. In its 2011 report on risk-tolerance assessment and suitability, the then FSA provided specific guidance on how risk profiling should be performed, including how to address mismatches between a client’s risk tolerance, risk capacity and required risk. The guidelines state:
- In circumstances [in which] a customer’s needs conflict with the level of risk a firm has established the customer is willing and able to take, we expect the firm to have a detailed discussion with the customer. The firm should draw the customer’s attention to any mismatches in [his or her] investment objectives, financial circumstances, risk tolerance and capacity for loss. It should also explain the implications for the customer of making alternative trade-off decisions — for example, saving more, spending less, retiring later or taking [on] more risk.
- [In cases in which] the customer does not have capacity to sustain the potential loss of a higher-risk strategy, the firm should explain that the customer’s need for a higher return cannot realistically be met.
As for Canada, the U.S. and other jurisdictions, however, FinaMetrica notes that risk profiling is still characterized by significant flaws, such as poor or non-existent assessment of the most critical risk factors; failure to consider the risk factors separately; inappropriate weightings being assigned to the risk factors; and resolution of mismatches being done by the advisor without the client’s properly informed consent. There’s much still to be done here to improve practices and safeguard Canadian investors in this key area.
The Canadian Foundation for Advancement of Investor Rights urges regulators across the country to develop detailed standards for risk-tolerance assessment swiftly and to make compliance with those standards mandatory for all advisors and their dealers as part of the KYC process. This will enhance consumer protection by reducing the incidence of unsuitable recommendations stemming from inadequate risk profiling. At the same time, it will also help advisors and dealers reduce their exposure to claims and disciplinary proceedings. It’s a potential benefit for everyone — and that’s an opportunity not to be missed.