Suitability is the concept of ensuring that the advice given is the most appropriate, that it is aligned to the risk profile of the investor and their personal goals and circumstances.
Author Andre Correia
Date 22nd August 2017
Considering that each investor is unique, this process requires an approach that can account for their personal preferences whilst delivering results that are consistent, reliable, defensible and compliant with regulators.
Establishing suitability relies, firstly, on determining the investor’s risk preferences, also refered to as their ‘willingness to take risk’. Using a psychometric Risk Tolerance assessment is the established 'best practice' and the industry standard. However, on its own, it is not enough to determine what type of investment is suitable for the investor.
With risk preferences revealed, the next step of establishing suitability will focus on the specific goals and circumstances of the investor. A crucial factor, for example, will be determining the time horizon of the investment. An investor in their 30s saving for their retirement has a very different time horizon to a wealth 50-year-old who’s investing to be able to buy a luxury purchase, such as a sports car. Knowing the time horizon is vital for understanding which type of investment is required.
The investor’s capacity for loss must also be considered. The investor may be very comfortable with high levels of volatility but do they have the capacity to bear the loss of the investment without severely impacting their current living standards?
Knowledge and experience of the financial markets, as well as the investor’s outlook on future performance, will be important aspects to consider. Extensive academic research has demonstrated the link between these unique factors for each investor and how they change their behaviours and preferences over time. Determining if previous losses have made the investor less confident, for example, can provide valuable insight into how likely the investor is to see their preference for risk decrease in the event of a downturn in their investment’s performance.
By using this type of suitability process, the adviser can be confident that the advice they are providing is suitable, defensible, and engages with the investor’s circumstances, enabling them to better understand their investment choices and make an informed investment decision.
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