New research from CFA Institute offers guidance for financial advisors to accurately assess clients
As the effects of the global outbreak leave investors shaken, advisors are under more pressure than usual to prove their value. From issuing market updates to fielding questions and making calls to reassure clients, the past few weeks have been a test for all.
When the dust settles and the world achieves much-needed equilibrium, advisors, along with everybody else, will likely want to pour themselves a much-needed stiff drink, get a massage, or indulge in the pleasure of their choice. But aside from that, they’ll need to address the important business of revisiting clients’ risk tolerances — and a new research report from the CFA Institute offers a useful framework.
“An important financial advisory skill is the ability to develop a comprehensive representation of an investor’s [investment risk profile],” the institute noted in Investment Risk Profiling: A Guide for Financial Advisors.
According to the report, while advisors must use their best professional judgment to assess the appropriate portfolio selection to let investors reach their financial goals, they must also acknowledge the possibility of negative returns by developing a robust investment risk profile (IRP).
It identified three factors that comprise an IRP.
The first is the risk need, which is the risk an investor must take on to achieve a specific goal. The report identified three elements that inform risk need:
- Rate of return;
- Market risk environment; and
- Consequence of failure, which refers to financial and emotional threats that arise from not achieving a goal.
The second factor in an IRP is the investor’s risk-taking ability, which is determined by their:
- Time horizon;
- Need for liquidity; and
- Risk capacity, or an investor’s financial capability to endure a financial loss without substantially compromising their desired standard of living.
Finally, an IRP should consider an investor’s behavioral loss tolerance, which comprises elements that “tend to be subjective and unique to each investor.” Aside from using the right KYC tools such as properly designed questionnaires, tests, scales, and client conversations, advisors must take note of investor’s past behaviour with respect to asset-allocation decisions to determine their behavioral loss tolerance.
The elements of behavioral loss tolerance, according to the report, are:
- Risk tolerance;
- Risk preference;
- Financial knowledge;
- Investing experience;
- Risk perception; and
- Risk composure.
“[F]inancial advisors face the real risk of failing to meet an investor’s goal(s) if a selected portfolio is positioned either too conservatively or too aggressively,” the report said. “To increase the likelihood of achieving investor goals, financial advisors must use tools that fully inform professional judgment when making portfolio allocation recommendations.”