What makes an investment selection suitable? There is a near-unanimous understanding, among regulators, advisers, and the subset of investors engaged enough to listen to either of them, that it’s about matching the investment risk someone is both willing and able to take with the risk actually being taken.
And while Risk Tolerance is generally well-understood to represent willingness to take investment risk (even if widespread errors in assessing risk tolerance and mistaking risk tolerance for the overall risk profile remain frustratingly common), there’s rather less understanding of what ‘ability to take risk’ actually means in the context of a human owning and interacting with investments.
This is concerning. Because this particular lack of understanding lies behind many of the most common and costly errors we see in suitability. For example, using the inadequately narrow notion of ‘capacity for loss’ as a proxy for Risk Capacity (see here for a detailed look at the problem with that). Or, as is the subject of this article, overlooking the fact that the ability to take investment risk comprises both financial and emotional elements.
Defining Behavioural Capacity
In addition to their financial ability to take risk, as assessed by Risk Capacity, each investor has an emotional ability to take risk: a Behavioural Capacity that determines how best to interact with one’s investments to ensure ongoing comfort with the risk being taken.
An investor’s Risk Capacity determines how their financial circumstances affect the right level of investment risk for them to take right now. How reliant are they on their investible assets to fund their current and future lifestyle?
An investor’s Behavioural Capacity shapes how their financial personality should influence both the investment risk they are asked to live with today, and the way they are helped to view, understand, and interact with their investments over time. What role does their financial personality play in managing both which investments to own and how they’re perceived?
For example, often the most important element of an investor’s multi-dimensional financial personality is their Composure. Composure is a measure of an investor's comfort or anxiety with the ups and downs along the journey. A Composure score reflects an investor’s tendency to get emotional with the present state of their investment journey (and also external stimuli such as the news).
Many investors have levels of Composure which differ considerably from their long-term Risk Tolerance: their reasoned willingness to trade off the risk of lower long-term outcomes for the possibility of higher long-term returns. Most advisers will recognise the client who is, in principle, comfortable with the trade-offs of taking higher long-term risk, but who is quickly on the phone when they experience the journey this entails. The destination may be suitable; the route may still feel unbearable.
This is why Composure matters for suitability. For low-Composure investors, it may be necessary to moderate their Suitable Risk Level, and should also limit how far Risk Capacity adjustments can lift that level above Risk Tolerance. But even where low Composure does not change the long-term portfolio suggested by Risk Tolerance and Risk Capacity alone, it should change how the investor is supported along the journey. These are the investors most at risk of turning temporary discomfort into permanent financial damage by acting on emotional impulses at precisely the wrong time.
Composure is only one part of a financial personality. In practice, when considering how an individual perceives their portfolio amid changing personal and global events, even in the simplest of situations, there are limited benefits to offering suggested actions based on a single aspect of financial personality in isolation. While it’s crucial to assess each personality aspect independently, the best prescriptions for action come from understanding someone’s whole situation.
Unlike Risk Tolerance, which is a single, relatively stable personality trait, Behavioural Capacity reflects the multi-dimensional and highly context-dependent nature of an investor’s emotional ability to live with, interpret, and act around investment risk. It would make no sense to talk of a single ‘Behavioural Capacity score’. Instead, we assess emotional ability via financial personality across several dimensions, depending on the nature of the advice being sought (e.g. there are fewer relevant dimensions for a specific scenario under Targeted Support than for fully personalised advice).
Zombie Suitability
At this point, it’s fair to ask: if Behavioural Capacity is such a vital component of a suitability assessment, why is it so commonly overlooked? Aren’t we all just getting along fine without it?
The endurance of this error is a legacy of the profession’s past life as a product-selling industry.
Slowly but surely, the focus within financial advice is shifting from products to people. In the midst of this transition, while the more explicit expressions of the past – such as commission-based remuneration – have been largely silenced, the old ways continue to echo through the plumbing: we’ve noted that investors are humans, but we continue to treat them like robots.
In the absence of an assessment of emotional ability, you don’t have human suitability, you have zombie suitability: suitability for something that looks like a human on the outside, but which relies on it having no consciousness on the inside.
The financial-planning profession increasingly acknowledges that different people receive the same messages in different ways, and that merely disclosing risk warnings and showering each investor with a firehose of fact-sheet information doesn’t work… but then does it anyway. It sees the imbalance between helping investors understand investment management and helping advisers understand investor management… and then doubles-down on the devil it knows.
Few would argue against the importance of investors’ behavioural traits as factors hindering good decision-making and understanding, nor the importance of behavioural design and technology in improving consumer outcomes. However, in practice, there is still too little consideration of three crucial points: that differences in behavioural traits may change what solution is suitable; that ignoring these traits can be costly for investors; and that, with the right behaviourally conscious technology, we can now do something about it.
Consumer Duty should make this harder to ignore. If firms are expected to avoid foreseeable harm, support customers in pursuing their financial objectives, and communicate in ways people can actually use, then an investor’s emotional ability to live with a solution is not a decorative extra. It is part of whether the solution is likely to work for the human being who has to own it.
Suitability by Design
Suitability is, in many ways, still shackled to the point of sale, rather than something that accompanies the entire period of ownership. Yet investing is a long-term, lifestyle-centric journey, not a short-term product-centric event. It’s time suitability processes were better designed to reflect this. Understanding and adequately accounting for Behavioural Capacity is a non-negotiable part of this.
