Risk tolerance is the amount of loss that an investor can tolerate or absorb in the event that his or her investments depreciate in value. Risk tolerance changes with age, employment situation, income, investment knowledge, marital status, and other priorities in life.
It is not uncommon or unreasonable for clients to want investment vehicles that provide them with high returns at little or no risk. You must make your clients aware that investments that provide an opportunity to earn higher returns are also those that carry a higher degree of risk.
Risk tolerance is not just the client’s comfort level or attitude toward risk, but also his or her actual ability to withstand financial losses. You should therefore determine your client’s risk tolerance as the lesser of your client’s comfort level with risk, and his or her ability to withstand declines in the value of his or her portfolio.
Assessing Risk Tolerance
One of the most common allegations made in client complaints to the MFDA is that the assessment of the client’s risk tolerance was incorrect. Clients allege that the risk tolerance indicated on the KYC form was higher than that which the client asserts is his or her actual risk tolerance.
You may face disciplinary action if you make an inappropriate recommendation for a client’s risk tolerance level.
For these reasons, it is highly recommended that you use some form of risk profile in assessing a client’s risk tolerance.
Investment objectives are among the most important considerations when dealing with clients. These objectives form the basis of investment planning and subsequent sales of fund units to clients.
Investment objectives used for suitability assessment should be specific, for instance, income, growth, or capital preservation. Clearly specifying the client’s investment objectives will help you to make investment recommendations that are suitable to the client’s investment needs. Investment objectives must be distinguished from the broader, overall objectives of the account such as “retirement savings” or “tax planning”.
Investment objectives are often categorized as:
- Capital preservation
- Growth of capital
- Speculation, or aggressive growth of capital
In addition to the primary objectives listed above, a client may also be interested in secondary objectives such as tax deferral or liquidity. For instance, a married couple in their mid-60s may be drawing a retirement income. Their typical priorities are to preserve capital and generate regular income. However, a younger investor may be more inclined to invest for longer-term growth. By investing for growth, the younger investors hope to be able to meet their future financial needs.
Time Horizon is the period from the initial investment to when the client may need access to a significant portion of the money invested.
It is incorrect to assume that all young clients have long time horizons, and all older clients have short time horizons. You must know your clients and their individual needs.
Identifying a Suitable Time Horizon
A client’s stated time horizon is important when considering the fee structure of a mutual fund. Generally, it is considered unsuitable to recommend to a client a mutual fund that has a fee schedule of longer duration than the client’s time horizon. Likewise, a financial product that has liquidity restrictions for a period longer than the client’s time horizon would be considered unsuitable.
Investment knowledge includes what a client knows about: investing, investment products, and their volatility and associated risks.
Investment experience is not the same as investment knowledge. You cannot assume that because a client has previous investment experience that he or she has investment knowledge. Some clients may know a great deal about investing and various types of investments without ever having made investments. Other clients may know very little, despite having numerous previous investments.
Becoming familiar with your client’s level of investment knowledge helps you to determine the types of investments you can recommend.
A client’s age is important for several reasons:
- There is a legal age of majority in each province.
- Agreements, including the purchase of mutual funds and other securities, entered into by people who are not of legal age may not be enforceable.
- Your client’s age ties in closely with his or her short-, medium- and long-term financial goals.
For instance, a 25-year-old single man with 40 years until retirement will likely have different investment objectives and risk tolerance than a man of 60 who is approaching retirement.
There are age restrictions for certain accounts, such as Registered Education Savings Plans (RESPs) and Registered Retirement Savings Plans (RRSPs).
Net worth denotes wealth. A client’s assets minus their liabilities equals their net worth. Knowing a client’s net worth is critical in assessing his or her financial condition. It helps you to determine the client’s resources and ability to invest, as well as any tax implications that may affect investment choices.
At higher levels of net worth, reducing tax exposure is often a priority. Please note that it is best to refer a client seeking specific tax advice to a qualified tax professional.
Net worth information should be computed in detail, showing liquid assets and fixed assets, and fewer liabilities. You should have a detailed view of the client’s net worth in order to be able to recommend suitable products.
Annual income is a critical factor in assessing an individual’s financial condition. For instance, a client’s annual income may indicate whether the client will depend on the income generated by their investments to cover their basic living expenses.
Generally, clients with low income also have a higher need to preserve their principal. These clients can usually be expected to have lower risk tolerance.
Computation of annual income should include income from all relevant sources. It should be collected as a number, or by using reasonable ranges.
You need to know about your client’s occupation in order to know the nature of his or her income. Some clients may have seasonal jobs or be paid on commission. In these cases, their income may vary dramatically from year to year. You should recognize the potential gaps in your clients’ income and work with them to meet both short-term liquidity needs and longer-term investment requirements.
Time To Test
Which of the following is a key objective of the Know Your Client rule?
To ensure that a mutual fund dealer has sufficient information about the client to enable it to carry out its suitability obligation.
|If you want to learn more about the content in this lesson, here are some links to other resources. You will only be tested on content contained in the course, not supplemental information found in these resources.|
|National Instrument NI 31-103||osc.gov.on.ca/en/13596.htm|
|MFDA Member Regulation 0069||mfda.ca/regulation/notices/MR-0069.pdf|
|MFDA Rule 2.2.1||mfda.ca/regulation/Rule2.html|
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