A good suitability assessment is greater than the sum of its component parts. Each of those parts must be measured, and measured well, but the way in which you measure them, especially with an eye on how they all fit together, is just as crucial as what you measure in the first place.
The Principles of Good Suitability Assessments
Traditionally, suitability assessments have focused on what to measure. To stay on top of the suitability game requires a better focus on the way in which you measure them.
The mandatory list of what to measure to demonstrate that investment recommendations come from a suitable, compliant, process has expanded. It now includes risk tolerance, risk capacity, knowledge and experience, sustainability preferences, and – if you squint a bit – behavioural proclivities.
This expansion is to be welcomed. However, you would be on dangerous ground were you to think that ticking off every item in whatever way felt most efficient is good enough. This would miss what suitability is ultimately trying to achieve: a better outcome for an individual investor, not only at the point they invest, or withdraw, but throughout their investment journey.
The most recent regulatory changes from both the UK (Consumer Duty) and the EU (MiFID II, especially the 3rd April 2023 Guidelines) have started spelling this out explicitly.
For example, there is clear recognition that the message a firm sends is not always the same as the one a client receives, and that mere disclosure of risk warnings isn’t good enough: effort must be made to ensure those disclosures are effectively understood.
As we’ll see below, the guidance also specifically points out that asking a client to go through a long list of products and tick off those they’ve previously owned is a terrible way to measure their relevant knowledge and experience as it applies to the suitability of them owning those (or other) products, in future.
The key to understanding and working with the latest regulations is to recognise that there is a clear direction of travel away from product-specific, isolated, independent, tick-box requirements, and towards a broader view that sees each client as an integrated whole human, rather than a mechanical construction of component parts.
Telling advisers what to measure is easy. Telling them the way in which to measure is hard. A checklist of independent requirements is easier to legislate directly than client-specific, context-dependent, outcomes.
Rules for context-dependent situations cannot be made prescriptive: there must be room for each advisory firm to express their investment philosophies through their suitability approaches. This is why each time the regulators release additional guidance on how their rules are to be interpreted, they can be summarised as ‘We know we said you must measure A, B, and C, and you must, but please remember that these are in service of outcomes X, Y, and Z.’
It’s the outcomes on which advice will be judged, not the boxes you ticked along the way.
You must still measure what can be measured, of course, and measure it well (something that the proliferation of poor risk tolerance assessments shows is not always as easy as it may first appear). But there’s a big difference – to you, your clients, and the regulators – between measuring something in a way that’s designed to fill a gap in a file, rather than fill a gap in an adviser’s understanding of an investor.
Measuring each aspect of suitability in a scientifically reliable and valid way, and appropriately combining them in an overall, outcome-centric process is hard. But with the right tools you can make it easy for yourself, and engaging for your clients.
Measuring each aspect of suitability in a scientifically reliable and valid way, and appropriately combining them in an overall, outcome- centric process is hard. But with the right tools you can make it easy for yourself, and engaging for your clients.
Oxford Risk’s approach, and our tools, are built on four core principles:
- Assessing suitability is a (behavioural) science
When the stakes are as high as someone’s life savings, it’s not the time for guesswork or pseudoscience. - Investor management and investment management are intertwined
Personal finance is behavioural finance. You can’t divorce investments from their owners. - Humans and tech perform best when they play together
Managing moving financial and emotional parts benefits from blending human and tech qualities. - Focusing on suitable client outcomes is compliant to the core
Meeting regulatory requirements should be a side-effect of a suitability process that seeks to understand what makes clients tick, not just tick boxes.
Read more about our core principles here.
Our tools help advisers identify a suitable investment solution based on each client’s holistic situation, including who they are (their financial personality, including their Risk Tolerance); what they have (mapping their whole balance sheet); and what they want (their cash flows, plans, goals, and time horizons).
They equip investors with the comfort and confidence to make better financial decisions that allow them to make the most of their savings to support the costs of their long-term lifestyle choices.
Investments are owned by investors, not robots. Assessing who that investor is, what those investments are, and how one is suitable for the other, before and during an investment journey is a scientific study of investor behaviour. Our tools are more than a collection of optional add-ons; they are the symbols of a systematic, scientific approach to investor and investment management.
What Do You Need to Measure, and Why?
Risk Tolerance: Willingness to take investment risk
Risk Tolerance is an investor’s stable, long-term, reasoned willingness to accept the possibility of lower long-term outcomes for a greater chance of higher long-term returns in the context of their overall wealth.
When measured correctly, it is a feature of the person: a personality trait that shows their willingness, relative to other people, to put their wealth in investments whose value could go down, in the hope that they in fact go up. The ‘relative’ feature is important because it lies behind many of the flawed approaches to mapping investor risk to investment risk; we’ll look at this in more detail in the next section.
Risk Capacity: Financial ability to take investment risk
Risk Capacity accounts for what investors own (or will own) that affects what risk they should take. It covers investible and non-investible assets (the latter affect an investor’s reliance on the former, and therefore determine what investment risk can be taken) as well as future income (including inheritances) and expenditure (including gifts away).
High-priority goals are included in the calculation of Risk Capacity. Lower-priority or more distant goals are not. This is because any goals that aren’t high priority are essentially already contingent on the realised investment outcomes: if times are hard, and the investment portfolio has performed badly such goals are likely to be postponed, shrunk, or eliminated.
The importance of Risk Capacity lies in the fact that Risk Tolerance identifies the right risk for an investor’s overall wealth, which is only a step along the journey to identifying the right risk for investible wealth. What is the investment risk that should be taken, accounting for the risk or security offered by non-investible assets?
Behavioural Capacity: Emotional ability to take investment risk
In addition to their financial ability to take risk, each investor also has an emotional ability to do so: a Behavioural Capacity.
Behavioural Capacity indicates an investor’s tendencies to particular behaviours in different circumstances. It covers those aspects of an investor’s personality other than Risk Tolerance that can affect their emotional comfort along the investment journey and in their decision-making processes.
Compared to Risk Tolerance, emotional responses along the journey are less stable and likely to be affected by changing circumstances and environment. Providing support during that journey requires tailoring an investor’s experience to their unique psychological make-up.
Key personality aspects include:
- Composure – An investor’s tendency to emotional responses to the present state of their investment journey (and also external stimuli such as the news). It is a measure of an investor’s likely comfort or anxiety with the ups and downs along the journey.
- Confidence – How capable and comfortable an investor feels about their ability to make good financial decisions.
- Impulsivity – An investor’s propensity to act quickly and on emotional instinct when making decisions about investments and spending.
Behavioural-based prescriptions are often more about foregrounding and backgrounding than they are about on and off. For example, all clients should be reminded of core principles, but where repetition could be educative and engaging for a less-experienced client, it could be a turn-off for a more sophisticated one.
Knowledge and Experience
Knowledge and Experience is about ensuring an investor can realistically understand the essence of what they’re investing in. It’s a function of their relevant knowledge (and understanding!) of basic investing principles, as well as their personal and professional experience of investing. It also reflects to some extent the Confidence aspect of their financial personality.
Sustainability Preferences
Long gone are the days when advisers assumed investors weren’t bothered about the environmental, social, or governance consequences of their investments unless they made a point of saying so, or asked a single yes/no question about ‘ethical concerns’ on a fact find.
The European MiFID II directives even specifically require that sustainability preferences are assessed in a ‘sufficiently granular’ – and quite heavily prescribed – way. It is a further clear sign of the move away from advice being narrowly focused on isolated products and financial risk- return expectations.
MiFID II also specifies that sustainability preferences are assessed after ‘standard’ suitability, an indication of the importance of being clear about which financial trade-offs investors are willing to make to meet their social aims.
What Is The Best Way to Measure Each Aspect of Client Suitability?
It’s important for each assessment to focus not merely on what is being counted, but the consequences of the counting: what role does each component part play in the bigger suitability picture?
Isolated measures of Risk Tolerance and Risk Capacity are not much good without a robust methodology to combine them in arriving at a Suitable Risk Level. The best sustainability questions are pointless if they don’t guide you towards how to tailor both a portfolio and how it’s presented to the individual client in question.
Broadly speaking, each assessment should help an adviser understand either a client’s financial personality or their financial circumstances. Personality assessments will fundamentally differ based on whether what’s being measured is a long-term trait, or a short-term tendency. Circumstances should be assessed in a way that reflects the fact that they’re inherently dynamic.
Both psychological and material factors can affect a portfolio directly, or how decisions about that portfolio are made, or how best to communicate with a client. Crucially, individual assessments need to fit together within a robust methodology for determining a suitable level of risk for an investor to take right now. A random selection of instruments can’t claim to be an orchestra.
How To Measure Risk Tolerance
A good Risk Tolerance assessment:
- measures Risk Tolerance, and only Risk Tolerance;
- is robust, reliable, and repeatable across the same investor in different financial, emotional, or educational circumstances;
- works equally well for investors from different cultural backgrounds;
- uses a question set optimised for the strongest signal, which provides the highest reliability and discrimination with the fewest similar items included; and
- is measured in such a way to fit together with Risk Capacity in determining a Suitable Risk Level.
The vast majority of Risk Tolerance assessments fail on most of these counts.
Poor design can distort what you meant to ask into something quite different. You may think you’re asking: ‘How much risk are you willing to trade-off for better returns in the long-term?’, but are actually eliciting answers to the question: ‘How do I feel about taking investment risk this morning?’
Both Oxford Risk and the FCA are concerned that most tests that purport to measure Risk Tolerance actually do not.
The major problem with many profiling tools is their failure to cleanly separate what needs to be measured – Risk Tolerance – from other confounding factors, such as an investor’s perception of the risk of markets today, or their emotional reactions to those perceptions, or their financial knowhow, or their general numeracy.
Other major mistakes are about questions that are either too hard to understand, or too hard to answer accurately enough to be helpful… or too fun and trivial to be accurate.
See this article for more on how not to measure Risk Tolerance.
Risk Tolerance is best measured by a psychometric questionnaire using responses to simple statements elicited on a Likert scale (i.e. from completely disagree to completely agree). Knowing which items to include in such a questionnaire to avoid accidentally measuring something else, and to sidestep cross-cultural sensitivity to subtleties in question interpretation requires thorough testing.
Using a Likert scale has been shown in industry use and in academic studies to be stable over time and to adequately differentiate between individuals (i.e. with well-chosen questions respondents use the full response scale). Likert scales are extremely quick and easy for users to understand and complete. Each statement is related, but different. This is to ensure: a) greater stability than could be attained with a single statement, and b) that the resulting score does not rest solely on a single precise wording.
Risk Tolerance is also best assessed together with other financial-personality statements (though best assessed together, it’s vital Risk Tolerance, and each of the other personality aspects are scored separately).
For example, in the default Oxford Risk assessment the user answers 17 statements, just under half of which relate to Risk Tolerance, with the rest divided between Composure, Confidence, Impulsivity, and Familiarity Preference. This is more interesting to the client, improves accuracy by masking what is being asked and why (which risks people answering the way they want to be seen, and not the way they actually feel), and provides more valuable feedback than just Risk Tolerance on its own.
How To Measure Risk Capacity
A good Risk Capacity assessment:
- is dynamic;
- is a consistent calculation, not a workaround;
- is accurate without spurious precision;
- accounts for anticipated cash flows (including goals and their time horizons) automatically;
- accounts for current assets and liabilities; and
- is designed to fit with Risk Tolerance.
Whereas a client’s long-term reasoned willingness to take investment risk (as measured by Risk Tolerance) is stable, their circumstances are often not. A Risk Capacity calculation needs to account for these dynamic changes, ideally automatically.
Often, Risk Capacity is crudely based on a client’s age, or a rough estimate of their cash balance. This reflects both an inconsistent process, and the belief that Risk Capacity is something to be considered as an afterthought to Risk Tolerance, rather than frequently a more fundamental determinant of the right level of risk to recommend.
Where some Risk Capacity assessments err by oversimplifying, others err by placing excessive confidence in spuriously precise estimates. Precision and accuracy are often confused. In assessing capacity, trying to be ever-more precise (with, say, valuations, or forecasts) paints an increasingly inaccurate, and fragile, picture.
Oxford Risk’s technology is designed to give approximately right, but highly robust, solutions that are responsive to changes that we actually see, rather than give highly precise, but wrong, estimates of things we don’t see.
One way this problem manifests is in accounting for non-investible assets and liabilities. To ensure the right balance between protecting nearer spending needs and remaining invested to build wealth to fund future spending needs, non-investible assets should be suitability discounted to reflect valuation uncertainty, liquidity, and emotional attachment. The market value of non-investible assets and the emotional importance attached to them can change dramatically. However, neither can be confidently predicted. It is better to review both the valuation and the investor’s willingness to part with these assets and update the Risk Capacity assessment accordingly at each annual review than it is to place excessive confidence in ‘precise’ figures.
Accounting for an investor’s time horizon often causes unnecessary confusion. This is largely because the idea persists (quite possibly from too narrow an interpretation of the requirement to take into account ‘time horizon’ in relation to any investment product sales) that investors have a single time horizon. This may have made a certain practical sense in terms of reminding investors that for an investment to be suitable, it was very likely they should be considering it as a multi- decade endeavour, but the notion that investors have a single time horizon is nonsensical.
Each investor has multiple time horizons because they have multiple withdrawal points and multiple goals. Good risk capacity measurements manage time horizons automatically. Investment horizons should be determined by when you need cash: how long do you have before your option to choose when to sell expires? When will you need to make withdrawals, and how large might they be? As a needed withdrawal comes closer, you will want to reduce risk to protect it. But by how much? And how quickly? Our Risk Capacity tool does this by reducing risk only insofar as the time horizon (and certainty and priority) of future goals requires it, and dynamically adjusting this profile as spending goals come closer.
A major failing of most Risk Capacity assessments is that they are not designed to fit within a robust methodology for calculating a Suitable Risk Level. In Oxford Risk’s approach, Risk Capacity has a multiplier effect upon Risk Tolerance: if capacity is neutral, the Suitable Risk Level will match Risk Tolerance. Go far enough above neutral, and the Suitable Risk Level moves up (depending on behavioural constraints). Go far enough below, and the Suitable Risk Level goes down too.
This is because the only meaningful way to assess Risk Tolerance, and consequently what is a suitable level of risk for an investor, is to do so in relation to the investor’s overall financial position.
How much risk to take with investible assets must account for risks being taken with non-investible assets (including that human capital bound up in education, knowledge, and future earnings power). This ensures the overall risk level is in line with an investor’s overall Risk Tolerance. Because Risk Tolerance identifies how much risk you are willing to take with your total wealth position (which is different from your current investible assets) Risk Capacity is essentially identifying how much to adjust for your current situation.
A stylised example of how Risk Tolerance and Risk Capacity tend to interact over time is shown in the following diagram:
Risk Tolerance is the steady flat line that shows your willingness to take risk over your total wealth position. Of course, risk tolerance can change over time, but evidence shows it is pretty stable.
The Risk Capacity line shows how financial ability to take risk often evolves over a lifetime, particularly with regard to changing human capital.
When young, only a small part of your wealth is investible, and your future earnings provide the capacity to take much more risk with these small investments. Over time you convert your human capital into investible assets (if you save!) but your future earnings and savings potential decreases. At some point, your earnings and savings potential is outweighed by your future spending needs: at this point your human capital is zero. At this point, with negligible human capital your current investible wealth and your total wealth are equal: your Risk Capacity is thus neutral, and the right level of risk for your investible assets is the same as your overall Risk Tolerance.
As you continue towards retirement your future earnings decrease towards zero, and you have a human capital liability – in practical terms this means you have spending to fund but no income, meaning you will need to meet that spending from your accumulated wealth. Your Risk Capacity is now low: because you have future spending to fund you can’t any longer risk putting your investible wealth into the markets at your overall risk tolerance level. In effect your investible assets are leveraged by your future spending needs, which are your debt to the future, and your current investible assets represent more than your total wealth. Low Risk Capacity here means your financial ability to take risk with your investible assets is less than your Risk Tolerance.
If you kept your risk level high, you’d risk having to withdraw from your portfolio after suffering a large market downturn to fund your ongoing expenditure needs. This can create a calamitous spiral as to spend the same amount you’d need to sell a higher percentage of your portfolio, forever decreasing your ability to generate the returns needed for your spending needs in old age.
How To Measure Behavioural Capacity
Those aspects of an investor’s financial personality that determine their Behavioural Capacity (of which we saw examples above, such as Composure, Confidence, and Impulsivity) are, like Risk Tolerance, psychological, and so also best assessed with a psychometric questionnaire using responses to simple (but rigorously researched) statements elicited on a Likert scale.
As noted above, because of how people typically answer psychometric questionnaires, especially those with similar statements around a specific central theme, it makes sense to mix Behavioural Capacity statements in with the Risk Tolerance ones, to keep engagement and attention that bit higher, and stave off survey blindness.
It bears repeating that each aspect of financial personality, whether assessed together or not, must be scored separately.
How To Measure Knowledge and Experience
Knowledge and Experience assessments often come across as an afterthought, with negligible attention paid to either what is being assessed or how it’s to be applied.
Poor Knowledge and Experience assessments are characterised by misunderstanding what it is that actually determines how well equipped an investor is to understand what they’re investing in, and consequently how comfortable they’re likely to be while invested in it throughout their investing journey.
The typical approach – asking an investor to tick off a list of what sorts of investments they’ve previously owned – may fit neatly into a file, but it tells you very little of any practical use. Paragraph 47 of the 3rd April 2023 European MiFID II Guidelines even spells this out:
‘In assessing a client’s knowledge and experience, a firm should also avoid using overly broad questions with a yes/no type of answer and or a very broad tick-the-box self-assessment approach (for example, firms should avoid submitting a list of investment products to the client and asking him/her to indicate which products s/he understands).’
A good assessment includes non-subjective measures (such as relevant personal and professional education and years investing), though the focus should be weighted more heavily towards testing each investor’s understanding of basic investing principles, supplemented by psychological factors, specifically Confidence. These key principles include the relationship between risk and reward, and how investments tend to function and perform over time.
A principles-based assessment more directly targets what’s actually important. An investor’s understanding of, and belief in, the core concepts of investing is of greater relevance to an investor, and of higher concern to regulators, than whether they’ve previously owned a particular investment (with little to no indication of the circumstances in which they came to own it, nor how they felt about owning it).
Knowledge and Experience is inherently dynamic. Whether an investor wants to learn about their investment journey or not, they will be reacting to it, and those reactions will be shaping their future decisions. A heavily front-loaded and rarely revisited assessment misses this, in a way that could lead to an unsuitable investment selection, and would almost certainly lead to poorer communication throughout the journey.
How To Measure Sustainability Preferences
Oxford Risk’s Responsible and Sustainable Investing Assessment module measures multiple dimensions of sustainability preferences using identical scientific psychometric processes to our Financial Personality Assessment. Our extensive research, across thousands of investors from right across the globe, identified a set of core, stable, preferences actually held by investors (as opposed to merely ideas they may plausibly hold). This allowed us to create an assessment which shows how each unique set of scores compares to the baseline established among the research population of thousands of investors.
These preferences include:
- Impact Desire – How much investors want to align their portfolio to social and sustainability goals.
- Impact Trade-off – Investors’ willingness to accept reduced liquidity, extra risk, or reduced returns, in exchange for greater sustainability or social impact.
- E vs S vs G – Investors’ relative preferences between the type of impact they want to support, between environment, social, and governance.
There is also regulatory wording to consider when assessing sustainability preferences. Because the components of Oxford Risk’s approach are stable, real, measurable, preferences, they paint both a comprehensive and compliant picture of what it is an investor is trying to achieve.
The 3 April 2023 European MiFID II Guidelines do a good job of spelling out the regulatory expectations for the assessment of sustainability preferences. In summary, the basic requirements are to determine:
- Whether the client has any sustainability preferences (yes/no).
- If yes, how much of their portfolio do they want to be geared towards environmental (E), social (S), and governance (G) conscious investments in total (e.g. minimum 30%)?
- Recognising that environmental considerations tend to be the greatest concern of the three (something supported by Oxford Risk’s own research), within that total E, S, and G proportion, how much should be ‘E’?
- Whether there are specific ‘principal adverse impacts’ that need to be considered (the most common application being to avoid specific economic activities, such as mining, or arms).
Even where no sustainability preferences exist, or where they exist, but in a way that’s not aligned with the typical ‘E’, ‘S’, and ‘G’ categories, there must still be a clear, evidenced, process that preferences have been sought and, where they exist, a reasonable attempt has been made to incorporate them in any advice.
Putting It All Together: How to Determine a Suitable Risk Level
Measuring each aspect in a suitably reliable, robust, and repeatable way is fundamental, but it’s not enough on its own. A good overall suitability assessment is more than the sum of its parts. The individual assessments must be designed to fit together as part of a consistent, methodological process, and to deliver a Suitable Risk Level for each investor that maps to how risk levels are calculated for available investments.
The most crucial element is the methodology for combining Risk Tolerance and Risk Capacity. Excellent Risk Tolerance and Risk Capacity assessments are not much good to you without a solid scientific grounding for how they fit together.
It’s vital that Risk Tolerance is never used on its own to determine the Suitable Risk Level. It must be combined with a comprehensive and quantitative assessment of Risk Capacity (which will often be the more important component of overall suitability).
Understanding how to combine them starts with understanding that Risk Tolerance applies to an investor, not a particular set of investments. Risk Tolerance is the maximum risk the investor would be willing to accept over their total wealth in the long-term. The appropriate level of investment risk to take for specific investible assets, therefore, depends on the size of those investible assets relative to the investor’s overall wealth.
Note that this means that an investor’s Risk Tolerance is often not the maximum level of risk they should take with their investible assets. Frequently, investible assets will only be a portion of their total wealth, implying that they can potentially take more risk with this portion to balance the stabilising effect of non-investible assets.
It is wrong to think of high Risk Capacity increasing the risk profile above Risk Tolerance. On the contrary, high Risk Capacity raises the Suitable Risk Level for investible assets in order to bring the risk level of the investor’s overall wealth position in line with the investor’s Risk Tolerance.
We should be willing to accept more risk on an investment we could cope without, than on an investment we rely on as a main source of income.
How do you know you can trust your measurements?
One of the major troubles with suitability measurements is that it can be difficult from the outside to tell the difference between a good assessment and a terrible one. Moreover, the consequences, from the mis-assessment of the suitable risk for an investor to take, to unnecessary discomfort along the journey, can go unnoticed for years.
For example, many Risk Tolerance assessments use very similar- looking, simple, statements. However, though the final statements should be deliberately basic, the process by which they are chosen should not be.
Designing an assessment to ensure that it precisely reflects attitudes towards specific criteria (i.e. a single trait, rather than a combination of traits), is not the place for guessing what works and what doesn’t, or trusting that using broadly similar wording leads to the same precisely differentiated, robust and valid outputs.
It’s impossible to claim any sort of robustness in responses (and resultant risk groupings) without detailed analysis both of individual questions and the correlations between them. The final Oxford Risk assessments are the result of a testing and calibration process that filtered over 500 potential questions through several tests to choose a set that best balances accurate measurement of a particular psychological trait and dedicated user attention.
It can be hard to see the difference, but it does make a difference. And that difference could be enormous. An imperceptible difference up front can compound to a life-changing difference for an investor over time.
What Should You Do with the Outputs of a Suitability Assessment?
The outputs of suitability assessments are used in three broad ways:
- to make changes to an investment selection;
- to influence decision-making processes; and
- to tailor client communications.
Investment selection is predominantly a function of the interaction of Risk Tolerance with Risk Capacity, with a possible cap on the maximum Suitable Risk Level because of low Composure, and a possible limit on the range of investment options because of low Knowledge and Experience.
Decision-making processes are affected by several components of an investor’s financial personality, most notably Desire for Guidance (i.e. the extent to which an investor wants to be included in financial decision- making and the management of their portfolio), Confidence, and Impulsivity.
The best way to tailor client communications reflects each individual’s recipe of behavioural traits. Sometimes this could be directly related to a single trait, and sometimes it will be a function of a combination of traits working in unison.
Knowledge and Experience is in play here too: both in the current level of knowledge to be assumed in verbal and written communication, and in specific educational messages aimed at pushing those boundaries gradually further back.
How Can Oxford Risk’s Behavioural Suitability Tools Help You?
Our tools have been specifically designed to meet the challenges described above. They aim at a deep understanding of individuals rather than a cursory ticking of boxes. We recognise that investing is emotional, and work with this, rather than ignoring it. Our tests are tested to the highest standards. We support decisions throughout the investment journey, rather than relying on a battery of upfront assessments. And we see suitability as an integrated, interdependent system, not a collection of independent components.
Read about the core principles behind the design of our tools here.
To find out how Oxford Risk can help you, or to arrange a trial of our tools, contact us here.
