Benefits Of Enhanced Client Risk Assessment
Understanding and fulfilling clients needs is a key element of business strategies and essential to creating a competitive business advantage. Financial advisors need to understand a client’s risk profile, both risk preferences and risk capability, to provide suitable investment recommendations that client value.
The importance of providing suitable investments is highlighted in a recent survey of equity investor’s issues. Suitability is by far the greatest concern, with 39% citing this issue. The top three issues are suitability, service issues, and inappropriate advice, which together make up 56% to the total issues. In contrast, the financial industry tends to focus on performance, but investors rank performance only in seventh place.
Little guidance has been provided for determining individual risk capacity. Traditionally, risk preference has been viewed as an intrinsic and fixed individual characteristic. Clients are asked to self assess their risk preference, which then determines the investor’s life time investment glide pattern
The key factors that drive risk profile has been clarified by recent academic research. In addition to personal preference, financial circumstances play an important role. Important financial circumstances affecting risk capacity include wealth, age, education, family circumstances and employment circumstances.
Financial circumstances determine how well investors can weather the downturns in the financial markets. Wealth is a key factor, as accumulated wealth provides a buffer that can support an investor’s financial requirements during market volatility.
Human capital, through employment income, is the major factor in wealth accumulation for most people. Employment is not risk free, wage income can fluctuate. Background risk for employment depends on the industry, firm and individual job. Many individuals have a good idea of their employment risk. Education levels play a significant role in job security. Higher education levels have been found to be associated with lower unemployment risk. Age also plays an important role. Older individuals have fewer years before retirement, and less time for employment income to offset any financial shortfalls. In contrast, younger workers can be expected to have more years of employment income to contribute to wealth accumulation.
Family circumstances also affect risk capacity. Most individuals do not live alone, but are part of household. Households may include multiple working individuals, such as a married couple with both spouses working. The household may also include dependents, whose financial security depends on the working individuals of the household.
Purchasing a home is often one of the largest expenditures and assets in a household. Home purchases generally require a down payment. Needing a set amount of money at a set time reduces an investor’s risk tolerance for market volatility. Therefore, as the purchase date approaches, financial risk tolerance declines.
All of these factors, as well as individual risk preferences, should be considered in determining the appropriate level of risky assets in an investor’s portfolio. Academic research has established how to calibrate the level of risk with the appropriate level of risky assets.
These various factors should be considered when determining investment risk capacity. These factors will vary through the investor’s life time, making important to regularly review financial circumstances, and modify financial risk based on the investor’s current situation.
A competitive advantage is available for the financial advisor who can use risk factors and risk preference to provide their clients with the most suitable investment recommendation.