In the world of investment there is no one size fits all. A prudent advisor will recommend a plan based and built around your own personal circumstances and needs. “Investment suitability” is key.
There are no short cuts. Advisors worth their salt design a tailor-made investment strategy for each individual. These strategies are essential and form the core of your investment process and a sound financial plan.
What does “suitability” mean and how is it measured?
The Suitability Rule (Sections 8(1) (a), (b) and (c) of the FAIS General Code of Conduct) requires that all financial advisors have a duty to ensure their recommendations fit the unique circumstances of the client.
Suitability is not only a case of someone being a cautious, balanced or aggressive investor. There is far more to the full meaning of suitability with regard to investments.
It is the degree to which the product or service offered, matches the client’s financial situation and the level of risk tolerance. Any financial planning must be aligned with the client’s financial personality as well as his/her needs and objectives.
Each investor is different and the circumstances of each need to be identified through initial discussions and using risk profiling tools. The discussions must be fruitful and tools visual so that clients clearly see the degree to which they want to expose their capital to risk and what the possible rewards are.
Bear in mind that both attitude to risk and capacity for loss may be changed temporarily by die nature of vulnerability. An investor might suffer illness, divorce or retrenchment and it might become necessary to delay initial investment decisions for a period of time, or even change them to adapt to new developments.
The investment advice must be suitable to the client’s position at that point in time. Being a vulnerable client is not necessarily a permanent state of affairs. As the circumstances change, the financial advice must be adjusted accordingly.
Vulnerabilities may emerge over time and can change the risk profile of the client. A loyal and prudent advisor will be understanding and mindful and overcome biases.
Complicating the matter is that very low risk investments can be as damaging to an investor’s portfolio as very risky investments.
Interestingly enough is that the rule does not cover losses. Just because an investment is suitable, does not mean it is advisable or that it will be profitable. Suitability does not automatically imply risk-free. Similarly, unsuccessful investments are not necessarily unsuitable. No one can categorically predict the rise and fall of the market, and that is why financial loss may also occur from suitable investments.
Risky investments might have greater returns, but you could also lose your full investment. The reality is that most clients have financial needs which are impossible to address. At present projection rates, more than 94% of South Africans will not have enough capital to retire. Such clients actually require an unrealistic investment, but with regard to risk it is absolutely unsuitable.
The Suitability Rule merely requires that a financial advisor has a reasonable basis for recommending an investment or strategy. The advisor must know all the facts about the investment and why it would suit the investor perfectly at that point in time.
Hence, the sale of an annuity (funds only accessible at age 55) to a young client who needs reasonable access to money, would be unsuitable and could constitute fraud or investment negligence. Likewise, the advice to put money into risky investments, could be unsuitable for a conservative investor.
The suitability rule is also violated if the financial advisor does not fully understand the product which is recommended. An advisor must undertake sufficient due diligence to understand the potential risks with the recommended strategy or products. Ignorance is no excuse.
How is suitability ensured?
A risk profiling exercise is done to assess the investor’s emotional tolerance to risk financial capacity to risk perception of risk needs ideal asset allocation; and the expectation of returns.
This helps to create a plan that will attempt to meet the needs of the client, taking into consideration their views, insecurities and appetite for risk. Such a plan will provide the ideal asset allocation for investments, matching their goals which include cash flow, risk management and proper estate planning.
The essence of the plan is based on the principles of Treating Clients Fairly (regulatory framework set by the Financial Sector Conduct Authority) which place the clients at the centre and delivers a fair outcome for them.
Also required, are diversification principles across asset types, like property and equity, as well as diversification within asset types, like foreign and domestic equity. Additionally, diversification like small cap, medium cap or large cap equities.
This plan must be set out in clear documentation with a “reasons why” report documenting why the particular strategy is recommended and how it addresses the client’s investment objectives and preferences.
Providing suitable advice is one of the key outcomes of the FAIS Act. Section 16 of the Act specifically requires that a code of conduct must be drafted to ensure that clients will be able to make informed decisions, and that their needs regarding financial products are satisfied appropriately and suitably satisfied.