This is in response to a recent Ken Kivenko e-mail commenting on the MFDA Know Your Client “risk tolerance” input.
According to the MFDA risk tolerance “..is your willingness to accept risk and your ability to withstand financial losses.”
Risk tolerance in this context is talking about risk aversion and risk capacity and the two while related are actually independent of each other.
Risk aversion is a qualitative measure of risk and places a personal value on issues such as volatility, risk of absolute loss and the amount of either an investor is willing to assume/to accept in exchange for an uncertain opportunity of return.
Risk capacity is a quantitative measure of risk and for a given level of risk, a given set of financial demands on assets, and assumptions regarding risk and return, quantifies how much exposure an investor can actually take of a set of risks before those risks impact the ability of assets to meet short and long term financial security.
You can have a very aggressive investor with next to no risk capacity who will need a very conservatively structured portfolio because of their financial demands on their assets. The only way an aggressive investor with heavy financial demands can have an aggressive portfolio is to sacrifice financial demands, in other words dramatically reduce what they can take from their investments in order to be able to take risk.
The industry, as is, does not have the techniques and tools to adequately deal with this. Risk capacity is the best interests component of the equation, because while you cannot impose a risk aversion on a client you can certainly recommend a framework in which their risk preferences are compatible with their risk demands.
Suggesting that an adviser will assist with explaining how the risk capacity sits with the recommendation is a bests interests activity in my mind.
But of course, in order to be able to safely use risk aversion, you need to make sure this qualitative component is correctly set and this requires a very careful assessment of risk preferences to make sure they are being held objectively by the client.
A couple of other points amongst the myriad of those that I do not have the time to address in this post:
I also have issue with the following:
The MFDA define “Investment Objectives” as “The specific characteristics of investment products and how they relate to the achievement of your investment goals.”
I never thought that a client’s investment objectives were specific characteristics of an investment product….. they may align with such…but…
Time Horizon: according to the MFDA “This is the period from now to when you will need to access a significant portion of the money you invest in the account.”
A yield requirement of 4% can have a materially different impact from a yield requirement of 1%, yet neither may require any significant access to the capital in an account, yet they clearly have a “duration” and a significant impact on security selection. Also, what is significant? In truth significant is anything that can have a material impact on risk capacity; a yield differential of 1%, especially today, can have a significant and material impact on risk capacity. Therefore time horizon issues are clearly not adequately met by the KYC.