Advisors who manage other people’s money must respect the Financial Sector Regulatory Authority (FINRA) Rule 2111 for convenience. The rule that came into effect on October 7, 2011 legally obliges advisers to serve the best interests of their clients. To comply with the rule and determine suitability, advisors must consider a client’s risk tolerance, preferences and personality, financial situation and investment objectives.
Key points to remember
- As a financial advisor, managing other people’s money comes with great ethical and regulatory responsibility.
- Placing clients in the right investments means an appropriate level of risk and time horizon that has a high probability of meeting clients’ financial goals.
- Placing clients in inappropriate investments may result from investments that are too risky for their personal preferences or objective financial situation, or both.
1. Understand risk tolerance
Advisors know that understanding a client’s risk tolerance capacity is critical. In other words, their ability to sustain a loss. For example, it may not be appropriate for an investor who cannot afford to lose their principal to invest in stocks or even most fixed income investments. However, investors who can handle losses better have more potential to generate higher long-term gains.
The time horizon can also be correlated to the level of risk a client must assume. For example, a customer with 20 years temporary horizon may have a higher risk profile since over the long term returns are likely to align with historical market returns. A client planning to retire in five years should have a lower risk profile since they have less time to recover from a bear market.
2. Preferences and personality
Advisors often overlook client preferences and personalities when determining appropriate investments. If a client is relatively new to investing, avoid complex strategies such as options or derivatives. They need to educate a new investor on how each investment works so that they understand what is going on in the investment portfolio.
An advisor should also know if a client has negative opinions about a particular industry or company. For example, investing in alcohol or tobacco companies without knowing a customer’s opinion could lead to problems in the investment relationship. Investigating “socially responsible” funds if the client requests it is a good way to show that you understand them beyond their financial goals.
3. Current financial situation
Knowing a client’s current financial situation is arguably the most important of the four points in this article. A client in a high tax bracket could benefit more by investing in municipal bonds or tax-deferred savings vehicles than someone in a lower tax bracket.
Understanding the client’s liquidity needs is essential. If the client needs to be able to access the money immediately, an advisor may avoid investment vehicles such as annuities or long-term bonds, as withdrawing these investments early may result in redemption penalties or negative prices.
4. Investment objectives
Traditionally, most people view investing as a way to make money or earn interest, but neglect setting investment goals. Providing a client with an investment objective helps them better understand what they are trying to achieve. For example, an advisor who knows that a young couple has a goal of paying for a child’s college education may suggest a 529 college savings plan.
Knowing what a client needs not only builds trust within the relationship, but also allows the advisor to make changes to the client’s profile along the way to ensure the plan stays on track.
How does a financial advisor measure risk?
Financial advisors often use questionnaires to measure their clients’ risk tolerance. These questionnaires may require open-ended responses, encouraging the customer to share their feelings about losing money.
What challenges do financial advisors face?
One of the biggest challenges financial advisors face is managing client expectations, including performance expectations. Beyond that, other challenges include managing customer contact.
What do clients expect from their financial advisor?
The biggest thing clients expect from their financial advisor is someone they can trust. Beyond that, they are also looking for someone capable and competent.
Overall, an investment professional must understand the client before making investment recommendations. The more information gathered, the better the advisor is able to choose the appropriate investments. Not knowing a client could result in improper investment advice or loss of capital for the client, as well as a potential violation of FINRA Rule 2111.