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Key Elements in Investment Suitability

Assigning a portfolio to a client requires an understanding of the client’s financial objectives, personal and professional preferences, behavioural inclinations and financial capacity. This information is critical to select an investment that maximises expected return and minimises risk, but most importantly, that accommodates the client’s psychological comfort levels.

Risk Scopes

Portfolio allocation used to be based on the assessment of three factors: financial capacity, risk tolerance, and knowledge and experience. In recent years, Environmental, Social and Governance (ESG) criteria became part of the risk equation as a crucial element in the calculations of portfolio allocation and the risk-return trade-off. Thus, the attribution of a portfolio investment to an investor lies on the integration of the following four elements:

  • Financial scope (Quantitative Dimension of Risk Assessment),
  • Psychological scope (Qualitative Dimension of Risk Assessment),
  • Cognitive scope (Cognitive Dimension of Risk Assessment),
  • Sustainability scope (Values-Based Dimension of Risk Assessment).
investment suitability framework

Risk Dimensions

Determining the allocation of a portfolio investment to a client depends on four complementary dimensions of risk.

  1. Quantitative Dimension of Risk Assessment
    The quantitative dimension of risk refers to an objective benchmark of the potential loss of wealth due to market crashes or bear markets. This metric is risk capacity – the amount of wealth an investor is able to put at risk to achieve his or her financial goals while preserving well-being and avoiding financial distress – and can be derived from the client’s financial capacity. Hence, risk is related to statistics and the quantification of probabilities (e.g. a client may need to adopt a medium to high risk in their portfolio to achieve their financial goals).

  2. Qualitative Dimension of Risk Assessment
    The qualitative dimension refers to the subjective standard of risk. The risk appraisal depends on the subject’s preferences, perception of the markets, emotional comfort, psychological tolerance to losses, attitude towards risk-taking, etc. (e.g. despite the need for a higher risk in the portfolio, a client might only want to adopt a low to medium risk in their portfolio).

  3. Cognitive Dimension of Risk Assessment
    The two previous dimensions are strongly correlated with knowledge, experience and expertise (see Fig 1). The more educated and knowledgeable the investors, the better their decisions and the more risk they are willing to take. Thus, subjective risk evaluation is affected by lack of financial knowledge (literacy), unfamiliarity or inability to interpret numerical data (numeracy), complexity of the task when questionnaires are difficult to understand, insufficient experience of new investors, and so forth.

  4. Values-Based Dimension of Risk Assessment
    The last element in this equation is ESG criteria; people’s preferences regarding the incorporation of environmental, social and governance elements into investment decisions seeking to generate returns and growth that are sustainable into the future (i.e., ensuring a positive impact on our world and society).
investment suitability framework

Investment Suitability

This graph highlights the interaction between these elements.

  1. Preferences Assessment (Risk & Impact): To align portfolio recommendations with both the client’s risk tolerance and sustainability goals, advisors assess these preferences using both risk and sustainability assessment tools. This dual approach captures not only the level of risk a client is willing to take but also the societal or environmental impact they wish to achieve with their investment. Through this assessment, advisors gain insight into the client’s emotional capacity to endure fluctuations in market performance, as well as their desire for an investment strategy that aligns with their personal values.

  2. Subjective & Objective Risk: Combining Risk Tolerance with Financial Capacity offers a comprehensive view of both the objective and subjective sides of risk. Financial Capacity provides a quantifiable perspective on how much risk the client needs to take to meet their financial goals. In contrast, Risk Tolerance reveals the client’s psychological readiness to endure these risks, identifying how comfortable they feel about potential market downturns or periods of volatility. The interplay between these two dimensions bridges the gap between the level of risk the client needs to assume and the level of risk they are willing to tolerate. This nuanced understanding enables advisors to recommend a portfolio that not only meets the client’s financial needs but also aligns with their emotional resilience, supporting their ability to remain committed to the investment strategy.

  3. Portfolio Composition: The final portfolio composition results from the interplay between ESG Criteria and Financial Capacity, establishing a structure that balances desired financial outcomes with values-based considerations. By factoring in both the client’s financial resources and their interest in responsible investing, advisors can determine an optimal blend of asset classes, industries, and sectors that align with the client’s goals. This approach ensures that the portfolio reflects the client’s aspirations for both financial growth and positive societal impact. Combined with the client’s Risk Tolerance, this balance enhances engagement and satisfaction, reinforcing the client’s commitment to their investment strategy.

While these core elements form a solid foundation for assessing investment suitability, many other factors can further refine the assessment, such as tax implications, economic cycles, and life-stage considerations. However, understanding these basic principles provides a strong starting point, empowering clients and advisors to make more informed, personalised, and ultimately more satisfying investment decisions.

 

A Comprehensive Framework for Investment Suitability

Designing an effective risk assessment framework for investment suitability is essential for aligning client portfolios with their unique financial objectives and psychological comfort levels. A comprehensive approach that incorporates the quantitative, qualitative, cognitive, and values-based dimensions of risk enables financial advisors to gain a holistic understanding of each client’s circumstances. This nuanced understanding of risk assessment fosters greater investor confidence, enhances decision-making, and ultimately leads to more successful investment outcomes.

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