The relationship between an asset manager and his clients is largely based on trust. This trust is affected when investment results are disappointing and the client’s assets are less profitable than was discussed at the time of the advisory meeting. At times like this, the “true or real” risk appetite of the client often comes up. In many cases, this does not seem to correspond to the risk appetite at the time of the advisory interview.
- One of the most common practical issues of a Know Your Customer inventory is determining the risk appetite of a client. The risk appetite is divided into:
- The risk that the client can bear (objective risk appetite);
- The risk that the client wants to face (subjective risk appetite)
Objective risk appetite
To assess the degree of risk that the client can bear now and in the future, insight into his current and future income and capital position is necessary. The best way to do this is to identify the advisor based on current and future income, expenses, assets and debts of the client. In addition, the personal situation, such as the age, career and future perspective, are of course important. The maximum objective risk appetite can be determined by the asset manager based on these facts.
Subjective risk appetite
However, this does not say anything about the subjective risk appetite or the risk that the client wants to face. The AFM writes that the following matters should always be discussed with the client with respect to risk appetite:
- What is the maximum amount the client is prepared to lose? This requires you to make the risk tangible. As an example, show the client a “2008” scenario that occurs at the end of the period.
- Which intermediate fluctuations are acceptable? (To prevent interim changes to the portfolio due to the client’s state of mind)
- How bad is it for the client if the target is not met? In case of non-concrete goals (return), questioning the return targets is important and the impact of not achieving this target return must be discussed with the client.
The AFM also notes in its investigations that a large group of investment firms does not, or insufficiently, chart the risk appetite of its clients.
Risk & Trust
The relationship between a financial advisor and his/her clients is partially based on trust. When the results of the investment are disappointing and the client’s assets are less profitable than was thought, the trust between financial advisor and client is compromised. In these situations the “real” risk tolerance and risk appetite of the client often arises. In many cases this does not correspond to the risk appetite or risk tolerance at the time of the know your customer inventory.
Where does this deviation come from and, more importantly, how can we prevent this deviation from occurring or becoming too significant? The fact that these kinds of anomalies arise has to do with the way the human brain works and the fact that people rather talk about who they want to be instead of who they are. From the perspective of the SCOPE KYC Cloud solution, we are of course primarily interested in preventing the deviation
Expansion of risk appetite with risk tolerance
To obtain the most accurate picture possible of a client’s risk appetite, the SCOPE KYC Cloud solution uses:
- A structured inventory of personal data, financial position, knowledge & experience and all matters necessary to calculate the objective risk appetite
- Scenario analyses based on objectives, stock markets and the attitude of the client with regard to return vs. risk and determine the subjective risk appetite of the customer by means of a conversation.
The following new section has recently been added:
- A risk tolerance test to determine the subjective risk appetite of a client
For this risk appetite test, SCOPE has entered into a partnership with PlanPlus and FinaMetrica. FinaMetrica is an acknowledged market leader in the field of risk profiling and has developed a method based on a questionnaire with which the risk appetite of a person can be determined with a very high level of reliability. This questionnaire has been integrated into the SCOPE KYC Cloud solution and has become part of determining the risk appetite of the client.
By adding the risk tolerance test to the SCOPE KYC Cloud solution, an asset manager has everything he needs with the SCOPE KYC Cloud solution to initially determine the risk profile of the client, but also to monitor it over time. As part of the periodic review of the KYC file, the client will have to repeat this test periodically. Any changes to the risk appetite and willingness are of course preserved. By consulting the “history of the KYC file”, the changes in risk appetite can be made transparent over time.
In my next blog I will discuss the details of the risk appetite test. What makes the test so reliable, which controls are included, and what can you do with it?