Advisors must reconcile conflicts between a client’s risk tolerance, risk capacity, risk need, composure, previous experience, time horizon and more in determining an investor profile and resulting personalized investment policy. There is little or no body of knowledge on how these trade-offs occur or what constitutes a “best practice” in applying “Professional Judgment” to ensure client best interest are met.
Research by Shawn Brayman presented at the Academy of Financial Services Conference in Chicago October 2018 explored if there was a consensus among advisors on what factors are material in deriving a risk profile. The results were ambiguous at best.
- Capacity, Time Horizon and Tolerance (behavioural) are considered the most important factors to consider, in that order. Composure, Experience and Need were considered less important.
- About 40% of advisors feel a client’s lack of prior equity experience is immaterial while 60% feel it should impact the portfolio construction and potentially limit equity exposure.
- Four of five advisors felt that if a client had “more capital than goals required” they would explore reducing risk while one in five felt goals “change” so it is better to continue to maximize returns regardless.
- One of the biggest disagreements was whether a client can take more risk than supported by their profile to achieve their goals? Fifty-three (53%) percent of advisors say no and 47% say yes.
- One in three advisors believe a client’s display of a lack of composure warrants a reduction in equity exposure and 2/3rds say no.
- There was a wide range of beliefs of the relevance of time horizon as a material factor running from 3 years to 15 years.
The conclusion of the research was that there was no current body of knowledge, nor a consensus amongst advisors. The critical issue for planners is:
- Articulate your beliefs and policies and disclose these to clients for “properly informed consent”.
- Be consistent in application of Professional Judgement – do not make it up on a case-by-case basis.