Suitability, Recommendation Compliance and the Risk Tolerance Questionnaire Shortfall

Attorney Advising Disclaimer

Pursuant to FINRA regulations, including the newly revised "suitability" rule, brokers "must have a reasonable basis to believe that a recommendation [or]…investment strategy…is suitable for the particular customer based on the customer's investment profile."

Because "reasonable basis" sometimes can be misconstrued, the industry developed a risk tolerance questionnaire—a short series of multiple choice questions meant to provide an objective framework for determining an investor's investment profile and risk tolerance.

To achieve this, the test is scored and a single number generated, which is meant to correspond to a customer's risk tolerance level—for instance, a low number (e.g., 1) for conservatism and a high number (e.g., 9) for an aggressive preference.

Simple, right?

According to some academic economists and industry analysts, the questionnaire's simplicity belies its thoroughness, utility and accuracy.

For instance, because the simple questionnaire generates a single number, some analysts have found that when results are applied incorrectly to the wrong situations such as real-world complex settings, they "frequently misguide and deliver poor solutions."

In other words, the test is "too simple" and lends itself to generating "significant problems."

Dr. Geoff Davey researched risk tolerance and found it to be a psychological trait that is not constant, not durable and in constant flux—all attributes that run in contrast to the questionnaire's single-digit result.

Barclays Wealth Management's London office further states through its research that such decision-making is "complex and unstable," invoking a "multi-dimensional array of factors."

Researchers point to the problems posed by instability and over-simplification of risk tolerance questionnaires with examples of failures in using the single-digit scheme.

For instance, a lower risk tolerance score may place an investor in a conservative portfolio with a fixed allocation of, say, 10 percent stocks and 90 percent bonds with an expected 1 percent real return over 25 years. Reliance on risk tolerance, in this case, would prevent the investor from taking on more risk safely and prudently over the years, resulting in a loss of potential revenue.

On the other end of the spectrum, an investor with a high risk tolerance score may be placed in an aggressive portfolio and locked into an investment strategy that takes money away from other potential uses, such as medical care or simply trying to rectify a poor negative return.

The research concludes that risk tolerance questionnaires fail to address specific needs or circumstances, ignore goals and objects and ignore complex or confounding real-world "life" variables.

The questionnaire scheme is especially at odds with FINRA Rule 2111, which requires "customer-specific suitability." If the questionnaire is not customer-specific, it cannot possibly be suitable.

To meet the goal of "customer-specific suitability," investors should understand the criteria used to gauge conservative or aggressive objectives and be in control of their position on this spectrum with the ability to change goals or objectives when needed.

Investors thus may be able to evaluate objectives related to:

> Spending goals, or how much is needed for consumption and lifestyle;

> Savings or how much money to set aside for investing;

> Timing investments by identifying when savings and spending should occur;

> Risk level, which pertains to the conservative-aggressive spectrum above;

> Legacy or what assets to transfer to heirs or charities;

> Surety or a question of "certainty": Confidence that the above factors can work together.

These factors may run at odds with one another—for instance, the same funds generally cannot be both spent on lifestyle and saved for investment—so investors will have to preference each factor while weighing the tradeoffs and benefits of each decision.

This process may be more involved than the risk tolerance questionnaire and it certainly may be more complex yet after thorough consideration, it should produce objectives that are more tangibly defined and more personal or customer-specific than the questionnaire.

If you have invested with a broker or firm whose recommendations have been in conflict with your investment objectives or investment profile and such unsuitable recommendations have proven harmful to your investments or financial interests, please call The Law Offices of Jonathan W. Evans & Associates at (800) 699-1881 for an investigation and consultation.

News: Risk Tolerance Questionnaire Failure (Financial Advisor)

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