The guidance confirmed that the customer’s capacity for loss was their ability to “absorb falls in the value of their investment” and if the loss of capital would have a detrimental effect on a customer’s standard of living.
The determination of a customer’s capacity for loss is an important part of the overall attitude to investment risk assessment: how much can they afford to lose before they become worried, are unable to sleep at night, or are continually calling you? As we know it is far more complicated than this as each customer is going to be different. It is all very individual and subjective.
Conduct of business sourcebook 9.2 requires advisers to take account of a customer’s preferences regarding risk taking, their risk profile and ensure they are able financially to bear any related investment risks consistent with their investment objectives.
There is no ‘one size fits all’ solution in determining a customer’s risk profile and capacity for loss, it has to be a combination of tools: questionnaires, open questions, closed questions and complete engagement.
Another consideration is how long can the loss prevail as some customers’ capacity for loss will not accept short-term losses above their agreed capacity for loss and therefore not allowing the markets to ‘bounce back’. Other customers may accept losses above their capacity if it is short term while others may accept that the investment will need time to recover. It is all very subjective.
Therefore the customer’s different time horizons, both long and short-term losses, are a critical assessment which has to be clearly established. Another area to consider is if the client is a very cautious investor and whether the effect of inflation on their investment is an acceptable loss they are willing to accept.
This type of information needs to be carefully collated in order to accurately determine the outcome of the risk discussions with the customer and it will only come from full engagement with them.
In many ways it is about managing a customer’s expectations. What is the investment anticipated to do? How much is it likely to fluctuate and is this within the customer’s capacity for loss tolerance, short and long-term expectations and overall risk profile?
If there is a situation where the customer does not have the capacity to sustain the potential loss of an investment strategy, (in order to meet their objectives) the adviser must explain the consequences to the customer. If the risk is higher than the customer is willing to accept, or by reducing the risk profile, the chances are that the objectives will not be met. This situation can be carefully managed and, most importantly, recorded for both parties to agree on the outcome.
Questionnaires have an important role in determining the customer’s risk profile and capacity for loss but they can be limited, having a restricted number of questions which may not suit all customer situations.
The adviser and the customer cannot solely rely on the outcome of the questionnaire. There needs to be further engagement to make sure the customer understood the questions and to discuss the outcomes, such as, capacity for loss. It is the start of the process, not the end or the only process.
The number and type of questions asked is also important to consider when an adviser is choosing a questionnaire to use with clients. Too few questions and the outcome is likely to be inaccurate, too many and the message could be lost. As many questionnaires ask the customer to choose from a number of answers the results could be uncertain if the customer chooses the answer they most closely associate with rather than the correct one. Furthermore, where there is a ‘middle’ answer the customer may be drawn to it if they are unsure. Therefore it is up to the adviser to engage the client and make sure the answers to the questions are accurate and that the client has fully understood the question.
Questionnaires do provide a structure to a customer meeting allowing the introduction of the questionnaire to prompt discussions on risk and loss and this provides a consistent approach to customer meetings. They may not fit every situation or customer, but they are a useful tool to start the discussion process and to begin the engagement. For couples, separate questionnaires should be completed as again risk and loss are individual.
Careful consideration needs to be given to the questions used in an attitude to investment risk questionnaire as biased weighting of certain questions can lead to incorrect outcomes, especially on loss. For example, asking a customer if he can absorb a 10 per cent loss is irrelevant unless it is asked in conjunction with the customer’s time horizons and acceptance of short and long-term losses.
One area which is always a good starting point is to ask the customer if he has suffered losses in the past. Ask him when this was, how it affected him and how he felt. Open questions are a great discussion point:
• How did you feel when you found out about the loss?
• What was your initial reaction? And later?
• What is your understanding of ..?
• Remind me of..?
• Tell me about…?
From these questions the adviser should record the answers (with a copy going to the customer), cross reference them with the questionnaire to make sure they are consistent and confirm the customer’s understanding.
Therefore, in addition to the questionnaire the adviser should fully engage with the customer to make sure there is clear understanding of the outcomes agreed, particularly the client’s ability, and willingness, to accept loss and over which time horizon.
In order to protect yourself the discussions and agreements reached must be carefully and accurately recorded. Without this information the adviser and the firm leave themselves open to criticism in the future if there is ever a complaint. However, with accurate recording there is no ambiguity and the records provide a means of defence in the event of a complaint. We know from past experience that you can have the most detailed and lengthy discussions with your customer but if you do not record it the discussion is worthless.
John Wright is a compliance consultant for the financial services team of Bond Pearce
Capacity for loss is clients’ ability to absorb falls in the value of their investment and whether the loss of capital would have a detrimental effect on the customer’s standard of living.
If there is a situation where the customer does not have the capacity to sustain the potential loss of an investment strategy, the adviser must explain the consequences.
The discussions and agreements must be carefully and accurately recorded.
