Assessing your client’s attitude to risk is an essential element of the financial planning process. In addition, the regulator expects you to record how you have assessed your client’s risk profile and to review it regularly. Clients may have a different attitude to risk for different investments dependent upon the reason for investing and the time frame they are investing for.
Establishing a client’s attitude to risk
The suitability of an investment for your client is one of your key considerations as an adviser. Establishing your client’s attitude to risk is a central element when assessing suitability. It is necessary to record how you have established your client’s attitude to risk, which could be through meeting notes. Asking a client to assess their own attitude to risk on a numerical scale will invariably lead to a ‘central tendency’, that is, the client will choose the middle number. More scientific methodologies have evolved using psychometric questionnaires to get away from the default to central tendency. There are a number of products on the market and you may need to carry out some research to discover which one is most suitable for your business and your clients. In addition you will need to establish how your client’s attitude to risk fits in with their goals and objectives. Is it realistic compared with their resources and what they are trying to achieve. Might your client need to reassess their objective or take a higher risk with a tranche of their investment to achieve one or more of their goals.
Questions to ask a client
Here are some prompts to the questions you should consider asking your clients:
Financial resources: (assets, income versus expenditure, short and long term commitments, emergency fund, existing debt, other investments and savings, protection and pension arrangements).
Age of the client and any partner and dependants.
Tax status (now and in the future, CGT, IHT).
Objectives (the purpose of the investment, income or capital growth, timescale, accessibility.
Financial goals, aspirations, priorities and timescales.
Personal goals, aspirations, priorities and timescales.
Ability to understand and comprehend the concept of investment risk.
Questions to ask yourself:
How do you explain the concept of risk in a way that your client is likely to understand? This may differ from client to client.
If you use a risk scale, have you discussed different types of risk and agreed with your client where they sit on the firm’s risk scale?
When making recommendations, have you researched the choices for investment and the provider/manager market sufficiently and confirmed this to your client?
Have you explained to your client that external factors, such as a change in interest rates, property markets, equities, global economics etc., can affect their financial situation?
Have you explained the risks attached to the product, investment strategy or action recommended in a way the client is likely to understand?
Not just attitude to risk!
Risk profiling is a process for finding the optimal level of investment risk for your client considering their risk required, risk capacity and risk tolerance, where:
risk required is the risk associated with the return required to achieve your client’s goals from the financial resources available;
risk capacity is the level of financial risk the client can afford to take; and
risk tolerance is the level of risk the client is comfortable with.
Risk required and risk capacity are financial characteristics calculated using your financial planning software. Risk tolerance is a psychological characteristic which is best determined by way of a psychometric test.
Risk profiling requires each of these characteristics to be separately assessed so that they can be compared to one another. Risk capacity and risk tolerance both act separately as constraints on what your client might otherwise do to achieve their goals (risk required).
It is unusual for a client to be able to achieve their goals from the resources available within both their risk capacity and risk tolerance.
Where a mismatch between the risk required, risk capacity and risk tolerance has been found, your role is to guide your client through the trade-off decisions that are required to reach an optimal solution.
The final step in the risk profiling process is to ensure that the client has realistic risk and return expectations so that you can be given your client’s properly informed consent to implement the investment strategy.
They key then is to ensure you have recorded the discussions with your client fully and then replay these is the suitability report.