Category Archives: Regulation

You’re Using Your Risk Tolerance Questionnaire Wrong

Risk Tolerance QuestionnaireMost risk tolerance questionnaires get a bad rap. For many advisers, they are simply a compliance tool to appease the regulator. They add some value, but if it weren’t mandated, they probably wouldn’t use them. This negative mindset is rightly deserved due to the abusive use of risk questionnaires. Let’s get a few things straight…

  1. Risk questionnaires cannot tell you exactly how to invest.
  2. Risk questionnaires cannot cover the entire suitability process.
  3. Risk questionnaires cannot solely be used for prospecting.

The true purpose of a risk questionnaire is to help you know your client so you ask intelligent questions and recommend the best investments. Knowing your client entails understanding their goals, psychological risk tolerance, capacity for loss and behavioral biases. You cannot capture all of this in a questionnaire.

Investing should be goals driven but instead it’s compliance driven

Risk questionnaires should help you recommend investments and handhold clients during market ups and downs. Not prescribe allocations and securities. The FCA hinted this in their Financial Advice Market review published in March. A questionnaire cannot challenge a client’s misunderstandings or mistakes. This is what being an adviser is all about. Only you can do this.

The regulator has attempted to legislate trust between you and your clients but we know that’s impossible. It has resulted in the bizarre outcome where people are invested according to “what would pass an audit” instead of their long-term goals.

So what’s the solution? It’s twofold.

  1. Ultimately, the financial advice market will need to increase its standing in society so it has more trust and less need for regulation. Perhaps the greatest trust builder being increased education and professionalism across the ranks (which is happening). At the beginning of the last century medical doctors were widely decried for their quack cures and empty promises. A few decades later they were the most esteemed profession in the country. This can happen with financial advisers.
  1. On the risk tolerance questionnaire side, you should be ready to challenge the results of a risk questionnaire if it suits your clients’ greater long-term interest. Human judgment shouldn’t be completely dismissed. It just needs to be thought through and documented. Admittedly, going through a detailed question and answer session with a client is less efficient than a questionnaire but it will help you learn about your client’s overall profile in a way a risk questionnaire cannot.

As someone who leads a company that creates a risk tolerance questionnaire for advisers you might think it odd that I call out the limitations. On the contrary, I think this draws to attention the qualities and uses of an effective questionnaire. It should help you understand a client’s goals, psychological risk tolerance, capacity for loss and behavioral biases so you can ask intelligent questions and guide clients towards their goals. It should act as a client-friendly, 3rd party check in your process to ensure you don’t succumb to your own behavioral biases. Does your risk tolerance questionnaire do this?

How RIAs Should Prepare For The DOL Fiduciary Rule – Interview with Cathy Vasilev #FearlessFinancialAdvisorPodcast

A compliance focused interview with Cathy Vasilev on how financial advisors can better manage the changing compliance landscape. Cathy Vasilev is a founder and VP of Red Oak Compliance. She’s been working with RIAs and BDs for over 25 years and has considerable experience helping firms stay compliant.

In This Interview We Discuss…

0:37 – What is the biggest compliance issue facing RIAs and BDs at the moment?

02:12 – What are the main compliance requirements of setting up your own robo-advisor?

05:28 – Impact of DOL fiduciary rule on RIAs

08:00 – The first thing RIAs should do to get a handle on the fiduciary rule

11:10 – Common compliance mistakes

13:15 – Is compliance enforcement going up or down?

14:25 – How to use compliance to grow your business

16:05 – What advice would Cathy Vasilev give to his 30 year old self?

Resources

Pocket Risk Cathy VasilevLearn more about Cathy Vasilev

Interview MP3

 

Client Suitability Compliance: A Comparative Review Of The USA, UK, Canada and Australia

Suitability ComplianceWe can learn a lot from our neighbours, including how to manage a client’s suitability for a certain investments. The U.S., U.K, Canada, Australia and a number of other countries have produced guidelines around client suitability including the use of risk tolerance questionnaires. Below is an overview of where each country stands.

U.S.A. – Financial Industry Regulatory Authority (FINRA) and Securities Exchange Commission (SEC)

FINRA Rule 2111 discusses client suitability when advisors recommend investments. It states advisors must…

have a reasonable basis to believe that a recommended transaction or investment strategy involving a security or securities is suitable for the customer, based on the information obtained through the reasonable diligence of the [firm] or associated person to ascertain the customer’s investment profile. In general, a customer’s investment profile would include the customer’s age, other investments, financial situation and needs, tax status, investment objectives, investment experience, investment time horizon, liquidity needs and risk tolerance.

FINRA defines risk tolerance as a client’s “ability and willingness to lose some or all of [the] original investment in exchange for greater potential returns”. This what we would call risk tolerance and risk capacity. With regards to questions and questionnaires FINRA states they must not be “confusing or misleading“. Advisors are not forced to use a risk questionnaire but FINRA recognizes advisors use such tools as a best practice.

Financial Advisors regulated by the SEC are held to the fiduciary standard, meaning they must legally and ethically act in people’s best interest. The SEC provides little specifics on risk questionnaires. However, they do say any presentation of data must be clear and not misleading.

U.K. – Financial Conduct Authority (Formerly the Financial Services Authority)

The UK has the most prescriptive suitability rules in the world. In 2011 the FSA released “Assessing Suitability: Establishing the risk a customer is willing and able to take and making a suitable investment selection“. The assessment found that most advisors were not properly assessing client suitability for investment. Their main findings were that…

  • Advisors were not diligently assessing risk tolerance AND risk capacity
  • Advisors were not assessing clients’ investment knowledge and experience
  • Advisors were using poorly constructed questionnaires that could sway clients too far into aggressive risks. Questionnaires did not have enough granularity.

Since this paper was released standards for suitability investment have increased. All UK advisors now have to provide a Suitability Report when recommending investments to clients.

Canada – Investment Industry Regulatory Organization of Canada (IIROC) and Mutual Fund Dealers Association of Canada (MFDA)

Canada has a complex financial regulatory system due it’s decentralized government. Financial regulation happens at the national level and at the provence level. However, the responsibility for client suitability has been led by the IIROC and the MFDA.

The IIROC has a series of KYC (Know Your Client) regulations including the requirement to demonstrate a client’s risk willingness, financial ability, time horizon and investment objectives. There is no specific mention of using a risk questionnaire but KYC forms are encouraged.

MFDA has been significantly more prescriptive and even provided a basic “safe harbor” risk questionnaire for financial advisors. They are the first regulator to talk about the need to measure a client’s risk tolerance, risk capacity and risk needs. Jointly these represent a person’s overall risk profile.

Australia – Australian Securities and Investments Commission

The focus for Australian regulators is that best interests have been applied by the Financial Services Professional (FSPs). Professionals must ensure the financial products they recommend are suitable having regard to each client’s objectives, financial situation and needs. An important part of an FSP’s assessment of a client’s objectives, financial situation and needs is the knowledge of the client’s tolerance to risk.

The regulator goes a step further and states FSPs should “educate their clients about risk and reward” and ensure couples are assessed individually.

ASIC and the Financial Ombudsman are supportive of risk questionnaires but state FSPs should not be 100% dependent on their results. They should use their judgement in conjunction with a questionnaire.

Conclusion

Regulators support and acknowledge the concepts of risk tolerance, risk capacity and risk need. They are increasingly prescriptive about measuring these constructs however, they don’t want a client assessment to become a “check the box” exercise and have thus shied away from developing detailed questionnaires. What they are looking for is consistency, objectivity and diligence when advisors recommend investments to clients.

What Is Risk Profiling? Part 2: Let’s Stop Debating Definitions

In my previous article “What Is Risk Profiling – Part 1”, I showed how you can’t talk about risk profiling, without understanding risk. And that the definition of risk has changed over the centuries due to academic research and human experience.

The modern consensus is that risk is a mathematical and psychological construct.

This consensus is built on over 64 years of research. It starts with the mathematical Harry Markowitz and his followers who gave us Modern Portfolio Theory and the Capital Asset Pricing Model. Most recently Friesen and Sapp have added to the psychological by publishing mutual fund data showing that “investor underperformance due to poor timing” is consistent with “return-chasing behavior”. And return-chasing behavior is primarily driven by psychological biases and a lack of financial education.

So for financial advisors, risk profiling is the process of understanding your clients’ mathematical and psychological situation in order to give good advice. Take a look at the diagram below.  

What Is Risk Profiling

The mathematical and psychological situation of the client has been further broken down in order to translate into how financial advisors do their work. See diagram below.

Risk Need Risk Capacity Risk Tolerance Risk Perception

According to the Ontario Securities Commission who recently undertook a study into risk profiling and risk profile questionnaires, the terms are defined as follows.

“Risk Tolerance: The willingness of the client to take on risk. It can be defined through their attitude towards risk and is often described as a high/low risk tolerance.” Risk Tolerance is also regarded as the opposite of loss aversion. This is backed up by research from Rozkowski, Grable, Kahneman and Tversky.

“Risk Capacity: The financial ability of a client to endure any potential financial loss. Does the client have the financial ability and can they afford to take on the risk?” This is backed up by research from Hanna, Chen, Waller and Finke.

“Risk Need: Refers to the amount of risk that should be expected in order for a client to meet specific financial goals. Larger goals may require higher returns on investment that comes at the cost of higher risk.” This is backed up Markowitz and his followers.

“Risk Perception: A judgment that the client feels towards the severity of risk in association with the broader economic environment. This perception can be heavily influenced by the media and/or through lack of understanding of the risks. The influence of ‘risk perception’ and ambiguity aversion may be reduced by greater financial literacy, education or experience.” This is backed up by research from Friesen and Sapp.

Risk Composure: This is the likelihood that in a perceived crisis the client will behave fundamentally different to their rational self and may take action that could crystalize losses. It can be measured based on a client’s past decisions.

Risk Profile: The aggregate of all of these factors to arrive at an overall determination of a ‘sweet spot’ for a client, such that it maximizes their ability to achieve their goals but is consistent with the level of risk they are willing and can afford to take.

At Pocket Risk we agree with these definitions and the academic literature supports it.

These definitions are the culmination of decades of experiments by academics, the practical experience of advisors and increasingly the support of regulators in Canada, the UK, Australia, and India.

In order for advisors to best help their clients, they need clear definitions from regulators and the academic community. Now we have them, it’s time to build tools and practices that allow advisors to better serve their clients.

 If you have any thoughts on this article, I’d love to hear them.

3 Key Points to Understanding FINRA Rule 2111 on Suitability

FINRA 2111 Rule LogoIn 2011, the SEC approved two new modifications to existing rules on client suitability for investment.  The new rules were proposed by FINRA who’s stated purpose is to dedicate itself to “investor protection and market integrity”. FINRA was and is concerned about sales practice abuses and yield chasing behavior that could significantly impact investors during a market correction.

The new regulations came into effect in July 2012 and though they were aimed at brokers, even RIAs (Registered Investment Advisors) with a fiduciary responsibility took note. Having studied the regulation I found many of the key points were buried in long legal notices that were challenging to follow. Below I’ve summarized the key points surrounding FINRA Rule 211 on Suitability.

1.    Suitability

FINRA’s regulation states that firms and their associated persons “must have a reasonable basis to believe” that a transaction or investment strategy involving securities that they recommend is suitable for the customer. A reasonable basis to believe must be based on a proper due diligence process to ascertain a customer’s investment profile. FINRA then goes on to state which information about a customer is required.

  • Age
  • Other investments
  • Financial situation and needs – which likely includes questions about income and net worth
  • Tax status
  • Investment objectives – e.g. retirement plans
  • Investment experience
  • Investment time horizon
  • Liquidity needs
  • Risk tolerance

Firms are expected and obligated to learn as much about a customer as reasonably possible before recommending a course of action. However, if a client refuses to give certain information or if it is not available, a firm may still give a recommendation provided they believe they have enough information to give suitable advice.

Herein lies one of the challenges with the new regulation. On one hand FINRA is saying certain information is needed to give a recommendation but on the other it is saying firms can move ahead without the points above if they judge it to be suitable after completing “reasonable diligence”. Firms are thus encouraged to use their own judgment. At least until a client complains and a judge decides what is “reasonable basis to believe” in the suitability of a transaction.

2. What Is A Recommendation?

Understandably not all interactions with a client or prospective client can be considered a recommendation. If firms had to collect all the information required to meet the regulation just to speak to a prospect then their business would suffer heavily. As outlined in this extensive FAQ, FINRA does not define the word “recommendation”. What they do say however is that the normal distribution of marketing materials does not constitute a recommendation. They then encourage firms to read past notices so as to understand the word “recommendation”.

Certain communications would be considered a recommendation. For example an outbound-targeted communication encouraging the purchase of a security or an online portfolio analysis tool where clients input information and then receive buy and sell options.

However, generic electronic libraries of research reports on a website with buy and sell orders would not be considered a recommendation. The key differentiation appears to be targeting. If you are speaking to a specific customer or a group of customers who share a particular characteristic then it’s likely you are recommending a course of action and would need to follow the FINRA 2111 guidelines above.

3. What Is “Reasonable Diligence”?

As noted above firms are expected to complete “reasonable diligence” in understanding a client’s specific information. Reasonable diligence simply means asking the client for the information. FINRA doesn’t explicitly say how, though it’s likely to be via questionnaire. A broker can take a client’s answers at face value so long as the questions asked are not confusing or misleading. Additionally if the client exhibits signs of diminished capacity or other “red flags” then the broker can have reasonable course to believe their information is inaccurate and should be cautious about recommending  a transaction.

Conclusion

A lot more than can be said about FINRA 2111 and I encourage you to read the extensive FAQ, which digs into the nuances of the regulation. Thanks to this shift in policy it appears brokers are moving closer and closer to fiduciaries, which will have a significant impact on the industry.

Let’s continue the conversation in the comments section below.