Why it’s time to see KYC through a behavioural-finance lens

Pascal WealthTech President Mark Doyle urges advisors to rethink their approach to investor risk tolerance

Why it’s time to see KYC through a behavioural-finance lens

With the new regime of client-focused reforms (CFRs) taking full effect in 2022, advisors in both IIROC and MFDA channels are having to meet their know-your-product and know-your-client obligations. That means, in part, taking a fresh look at investor risk tolerance – which could require using a new lens.

“Beginning in 2022, financial advisors must meet a higher standard, with the need to be able to demonstrate that clients’ interests always come first,” said Mark Doyle, president at Pascal WealthTech, in a recent commentary. “To comply with CFR guidelines, it is essential for advisors to better understand their clients’ willingness and capacity to take on risk.”

During the March 2020 downturn sparked by the first impact of Covid-19, Doyle noted, Canadian retail investors sold a net $18 billion in long-term (non-money market) mutual funds. In March 2021, investors bought a net $14 billion, after the S&P/TSX Composite Index notched a 12-month total return of more than 44%. In effect, many investors wound up sitting on the sidelines as one of the great bull markets in history played out.

Some advisors may lament that behaviour, seeing it as yet another example of clients’ non-adherence to advice. But according to Doyle, the problem may boil down to a misalignment between advisors’ definition of risk and how clients actually see it.

“Do clients worry about standard deviation of returns? Hardly,” he said. “More likely, they are concerned about real life stuff, like running out of money in retirement or not having enough in their RESP to support their kids through university.”

While the financial services profession leans on concepts like downside risk, probability, and standard deviation, Doyle suggested that clients often don’t relate to that type of thinking. Consequently, advisors may not know how their clients will respond to a change in the markets.

Rather than speaking strictly in terms of returns and volatility, he said the industry has to use communication that encourages positive investment outcomes and promote emotional satisfaction among clients. That means recognizing that human beings don’t always think apply logical or long-term thinking, and are prone to making decisions based on instinct, emotions, and biases.

Because of that tendency, he said, investor risk appetite isn’t an unchanging investor trait, but one that changes over time. “A traditional KYC risk questionnaire completed during March of 2020 would likely generate a different risk profile than one taken during March 2021,” he said, noting how investors become risk-averse amid uncertainty and risk-seeking when times are good. “The degree of change for any investor will depend on many individual behavioural risk factors.”

With that in mind, he argued that advisors would do well to connect with their clients using behavioural finance-assisted tools and approaches. With a better understanding of each client’s risk range and skew – as behavioural risks are typically not symmetrical – they’ll be better placed to have clear conversation with the client, particularly with respect to how their risk appetite changes and how that information can fit into their portfolio construction.

“The first step is for advisors to ask better KYC questions than they traditionally have; questions that get to the possible range of client risk appetite and associated behaviours,” he said.  “If you can make that connection with your clients, they … will know that you now understand them; and that they understand themselves. That’s a basis for a true partnership.”


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