Factors Affecting A Client’s Risk Profile

Question 1

A client’s risk profile is made up of three factors.

What are these three factors?

Answer 1

1. Risk required
   The level of risk associated with the return required in order to achieve the client’s objectives from the financial resources available
2. Risk capacity
   The client’s ability to absorb financial losses resulting from an investment
3. Risk tolerance
   The level of risk the client is comfortable with

Note: these three factors are not always aligned and can be in conflict

Question 2

What are the key factors that affect a clients risk profile?

Answer 2

1. Time scale of the investment.
2. Amount of risk capital.
3. Investment experience.
4. Psychology.

Question 3

For each of the key factors that affect a client’s risk profile -

Explain each factor and what it entails

1. Time scale of the investment.

Answer 3

1. Longer timescales (e.g., 30 years for retirement) allow for higher risk (e.g., equities) to minimize shortfall risk.
2. Shorter timescales (e.g., 3 years) require a more cautious approach.
3. Clients may have multiple risk profiles for different financial goals.

Question 4

For each of the key factors that affect a client’s risk profile -

Explain each factor and what it entails

2. Amount of risk capital

Answer 4

1. Risk capital = Money that can be invested without affecting the client’s lifestyle if it’s lost.
2. High-net-worth individuals generally have higher risk capacity because they have more money available

Question 5

For each of the key factors that affect a client’s risk profile -

Explain each factor and what it entails

3. Investment experience

Answer 5

1. More experience with different asset types → Higher risk tolerance.
2. Less experience → Greater aversion to risk.

Question 6

For each of the key factors that affect a client’s risk profile -

Explain each factor and what it entails

4. Psychology.

Answer 6

1. Emotional reaction to investment volatility affects risk profile.
2. Some clients handle losses well; others may be highly risk-averse.
3. Just because an individual has lots of money to invest doesn’t necessarily mean they’re comfortable with losing it.

Question 7

What is the difference between Risk Capacity vs. Risk Tolerance?

Answer 7

1. Risk Capacity = The financial ability to take risks.
2. Risk Tolerance = The willingness to take risks.
3. Both act as constraints on achieving financial goals.
4. Many clients may struggle to meet goals within both their risk capacity and tolerance.

Question 8

Regulator’s View on Risk Profiling and Advice Suitability - 2011 Guidance on Advice Suitability

What were the key findings from Thematic Review?

Answer 8

Over 50% of unsatisfactory cases involved mismanagement of risk tolerance and/or risk capacity.

Question 9

Regulator’s View on Risk Profiling and Advice Suitability - 2011 Guidance on Advice Suitability

What were the specific criticisms made by the regulator?

Answer 9

1. Failure to properly assess client risk:
   A. Combining risk tolerance, risk capacity, investment term, and age into a single output.
   B. Overemphasis on risk willingness at the expense of other client needs.
   C. Poorly designed questionnaires with flawed scoring and weighting.
2. Over-reliance on risk-profiling tools:
   A. Tools had limitations that sometimes led to flawed results.
3. Poor descriptions of risk attitudes:
   A. Too broad risk categories, leading to poor investment matches.
   B. Large gaps between different risk categories.

Question 10

Regulator’s View on Risk Profiling and Advice Suitability - 2011 Guidance on Advice Suitability

What are the regulator’s expectations with regards to risk profiling?

Answer 10

1, Firms must discuss any conflicts between a client’s risk capacity and financial needs.

2. Clients should be made aware of any mismatches in investment objectives and risk tolerance.
3. If a client wants higher returns but lacks the capacity for losses, firms must explain the limitations.
4. If a client can take higher risks and agrees to do so, firms must document the rationale.
5. Suitability must be reassessed if a client needs to take on more risk than originally identified.