Risk Profiling Ethics: The Importance of Doing What's Right

Would you sell clients a financial product without fully understanding their appetite for risk? If you did, you’d likely violate numerous regulations mandating that you know your customers and only provide suitable financial products based on a full understanding of their needs.

Apparently, that doesn’t stop thousands of advisors from not talking about risks before recommending insurance or investments. According to a FinMason survey conducted last year, only 25 percent of clients who work with an advisor say they have spoken with that person about the market risks they face. Of those that have, fully 62 percent didn’t understand their advisor’s explanation and also underestimated how much they might lose in a market correction. These statistics come from a FinMason survey of 492 investors.

Now, FinMason, a Boston-based financial technology and investment analytics firm, did not spell out whether these conversations happened during the initial client needs assessment or after the person became a client. But it’s probably fair to assume that a significant percentage of the customers surveyed were thinking about pre-sale conversations with their advisors, who proceeded to make recommendations without having all client data in hand.

From an ethics perspective, these survey results are appalling. It frankly boggles the mind to hear that financial advisors provide services and products without comprehensive assessments and conversations about risk. How can they presume to know which life insurance policies, annuities, or mutual funds to recommend if they have only a sketchy understanding of their clients' ability to sustain a financial loss, both objectively and psychologically? Making financial recommendations without this knowledge appears to be gross financial malpractice, something likely to have errors and omissions implications if their client portfolios go south in the next market calamity.

Reacting to these findings, FinMason CEO and founder, Kendrick Wakeman, CFA, said, “At some point there will be another crash . . .. If investors do not know their risk of loss, they will have an emotional response. They will feel upset, betrayed, and litigious and many will sell when they panic.” Wakeman went on to urge advisors to talk with their clients about how much they might lose in a correction and to make portfolio adjustments, as needed.

Wakeman continues: “I understand that many advisors don’t want to potentially scare their clients with talk about possible volatility in the market. But if an advisor has a conversation about a crash now, in the light of calm markets, they can have a very rational discussion of why it is important to take that risk. The advisor can form a clear mental link between that risk and the potential rewards, like having a higher income in retirement.”

This “turns a potentially scary conversation into a healthy and productive one,” Wakeman added. “Investors now know how much they could lose and agree that it is important to take that risk to achieve their ultimate rewards,” he said.

Bottom line for advisors? Consider risk profiling—and all risk-related conversations—as an essential part of getting to know your clients. Furthermore, view them as something all ethical advisors should do prior to making a recommendation. It’s not only legally required, it’s simply the right thing to do from an ethical perspective.

What’s more, advisors owe it to their clients to do a comprehensive and accurate form of risk profiling, not just a brief questionnaire designed to generate asset-allocation percentages. A rigorous risk discussion should take into account the following four elements:

• Risk capacity, which is defined as the maximum amount of risk clients can afford to assume based on their financial resources. Said another way, risk capacity is a quantitative measure of a person’s total ability to absorb a loss. Risk capacity also raises the question of how their portfolio will function after a loss.
• Risk requirement or the level of risk clients need to incur in order to meet their financial objectives. If they have very aggressive accumulation goals, their risk requirement will necessarily be quite high.
• Risk attitude, which refers to how people think about and frame risk in terms of their own lives. This is more of a psychological construct, unlike risk capacity and risk requirement, which are quantitative.
• Risk tolerance, the fourth element (and, like risk attitude, psychological in nature) relates to clients’ cognitive and emotional ability to accept a financial loss, which is separate from their risk capacity or risk requirement.

To fully come to grips with client risk, you need to assess and discuss all four of these factors, not just one or several. It also means you should determine which elements your risk-profiling assessment questionnaire is targeting. Many only attempt to measure one or two of these factors, not all four.

However, here’s the key point: whatever risk profiling form you use, never forget that it is your ethical duty to come to grips with client risk. Failing to do that will put you on a slippery slope leading to incorrect product recommendations, unacceptable financial losses (from the client’s perspective), and ultimately, serious complaints and E&O insurance lawsuits.

Surely, doing the right thing is preferable to the nasty consequences that may occur if you don’t. Are you ready to take your risk-profiling duties seriously?

For information on affordable E&O insurance for low-risk insurance agents and investment advisors, please visit EOforLess.com. For information on ethical sales practices, please visit the National Ethics Association’s Ethics Center.