InvestmentsNov 15 2022

Matching client risk appetite with ESG preferences 

  • Describe how advisers can establish their clients' ESG preferences
  • Explain why this is important
  • Identify what greenwashing is
  • Describe how advisers can establish their clients' ESG preferences
  • Explain why this is important
  • Identify what greenwashing is
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Matching client risk appetite with ESG preferences 
Photo: Clay Banks/Unsplash

An adviser who can clearly state a client’s risk in a way that accounts for their goals, capital and appetite for risk will invariably be better equipped to provide relevant, holistic advice for their financial future and recommend the appropriate options for their clients’ needs and risk profile.

Assessing capacity for loss

Capacity for loss can sometimes be mixed up with tolerance for risk, even among advisers, so it is essential to understand the difference.

Put simply, capacity for loss is about someone’s ability to absorb a fall in the value of their investments, rather than their willingness to risk that outcome.

In the 2017 guidance consultation on the financial advice market review, the Financial Conduct Authority said: “If any loss of capital would have a materially detrimental effect on [the client’s] standard of living, this should be taken into account in assessing the risk that they are able to take”.

In other words, advisers must understand the extent to which a client depends on their investments for income or capital growth and whether they would still be able to live comfortably if their investments fell significantly in value. 

Assessing capacity for loss starts with a fact-find about the client’s financial situation, including outgoings, dependents, the client's cash buffer and any likely changes to income needs, as well as gauging their feelings about the degree of potential loss they are comfortable with taking.

That will often be followed by a deeper dive that establishes whether they can continue to enjoy a decent standard of living even if markets fall, with suitability kept firmly in mind. 

Cash flow modelling can facilitate this by factoring the client’s assets, income, debts and expenses to establish the target income they need to meet their overall expenditure. The parameters can be changed so that different scenarios (such as earlier or later retirement dates) can be modelled too.

Once capacity for loss is better understood the risk assessment process can be widened to account for ESG preferences.

But ESG preferences can also be part of the fact-find, with the added benefit of eliciting additional information for the risk profiling process and extending the know-your-customer requirement beyond their objectives and financial situation. 

Including ESG questions early on also provides a more comprehensive audit trail, as well as offering a way into an informative and value-adding ESG conversation with the client.

Assessing client attitudes to ESG and understanding the impact they want their investments to have will likely strengthen the long-term client-adviser relationship, especially if they feel their desires are listened to and reflected in their portfolio.

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