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The new legislation due to come into effect on Jan 3rd, 2018 stipulates that advisory firms must provide a suitability report for retail clients.
This new requirement relates to the increased focus on the concept of suitability and appropriateness when providing financial advice. According to the new guidelines, the following should be established by the adviser:
By assessing the client's knowledge and experience, the firm must determine whether the platform or service is appropriate for the customer. They should take into account the types of financial service, transaction and regulated financial instruments the client is familiar with; as well as, the nature, frequency, and volume of the client's transactions. It should also be established whether or not the client is a professional investor, by reviewing their level of education and their profession.
Appropriateness can be established by a 'knockout section' of the risk profiling process, to determine whether the service offered is appropriate for the investor.
Client's knowledge and experience
Requires the same criteria as outlined above for appropriateness: the types of financial services and instruments the client is familiar with; as well as, their transaction history, their level of education, and their profession.
Clients financial situation
The service must take into account the client's income extent and source; assets including liquid, investments and real; their regular financial commitment and their ability to bear a loss.
Client's investment objectives
This section accounts for the investment time horizon; risk preferences, risk profile and risk tolerance; and the purpose of the investment.
The process of establishing suitability might seem straightforward: the first two elementsâ€”knowledge and experience and the investment objectivesâ€”are easy to quantify, as is the time horizon.
The complexity comes with understanding an investor's overall risk tolerance and linking it to their preferred level of investment risk. These concepts are closely related, and difficult to establish without a dedicated solution.
Risk tolerance refers to a client's general willingness to take a financial risk, relative to other investors. This is quantified through a series of psychometric questions, carefully calibrated to ensure a reliable output.
Risk preferences, the key metric to establish suitability, relate to how investors with different levels of risk tolerance align themselves according to the available investment choices. Providing an investor with the generally preferred levels of risk taken by other investors with similar risk tolerance and investment time horizon is a critical component for establishing what solutions are most appropriate and allows investors to make informed decisions with an adviser.
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