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February 25, 2016

Emerging Concerns About Risk Tolerance and Suitability

These two things have not fallen off FINRA's radar

Tyler D. Nunnally

The year 2016 is off to a shaky start. Stock indexes around the globe dropped sharply on the opening day of trading and markets continue to be volatile. As 2016 unfolds, no one really knows whether the beginning of the new year is going to mark the start of a prolonged bear market or simply be dismissed as inconsequential. Markets can be very unpredictable.

One certainty, however, is that volatile markets make investors emotionally uncomfortable. A measure of a person’s financial risk tolerance is supposed to determine just how uncomfortable an investor is likely to feel relative to market movements and the risks inherent in investing. In that sense, risk tolerance assessment is meant to be predictive by design.

There is a significant amount of risk tolerance research in academia, but generally there is widespread misunderstanding of the subject throughout the securities industries. These misconceptions translate into difficulties in the assessment and measurement of risk tolerance. This is unfortunate because an accurate measure of investors’ risk tolerance helps advisors recommend investment strategies that their clients can emotionally stomach during turbulent times. By sticking with their financial plan through good times and bad, investors are better able to achieve their financial goals.

Conversely, an unreliable measure of risk tolerance can cause advisors to recommend investment strategies that are outside their clients’ comfort zone. In the worst-case scenario, this can lead to a panicked sale during sharp market declines. Investors throw in the towel because they can no longer tolerate the emotional stress that they are experiencing as a result of suffering financial loss. These types of scenarios often end up in arbitration or court. “Taking too much risk” is a common refrain in investor complaints.

The Financial Industry Regulatory Authority (FINRA) emphasized the significance of risk tolerance in May 2012 with the issuance of Regulatory Notice 12-25. New FINRA Rule 2111 on suitability introduced risk tolerance as an explicit customer-specific factor that firms and associated persons must attempt to obtain and analyze when making investment recommendations to customers. The implementation date of July 9, 2012, has since passed, but risk tolerance has not fallen off FINRA’s radar.

FINRA is currently evaluating practices employed by the securities industry to collect and measure investor risk tolerance as part of the organization’s emerging regulatory issues review. Based on reviews from other regulatory agencies, there are concerns that existing practices are insufficient and that the inadequacies can lead to unsuitable investment advice.

British and Canadian regulators studied a number of widely used risk tolerance assessment tools and found that the vast majority were “not fit for purpose.” Financial Services Authority, Assessing Suitability: Establishing the Risk a Customer Is Willing and Able to Take and Making a Suitable Investment Selection (Jan. 2011); Shawn Brayman et al., Current Practices for Risk Profiling in Canada and Review of Global Best Practices (Oct. 28, 2015) (prepared for the Investor Advisory Panel of the Ontario Securities Commission). As part of the British study, regulators determined that more than half of suitability claims related to the fact that investment selection did not meet the investor’s attitude toward risk.

Moreover, the Department of Labor is mulling the introduction of a new fiduciary rule that binds investment advisors of retirement plans to a more stringent standard of care. U.S. Dep’t of Labor, Fact Sheet, Department of Labor Proposes Rule to Address Conflicts of Interest in Retirement Advice, Saving Middle-Class Families Billions of Dollars Every Year. The fiduciary rule poses significant challenges to the securities industry. One challenge that will have to be met by the industry and securities litigators is determining how best to mitigate breach of fiduciary duty claims tied to the risk tolerance assessment of plan participants. Juli McNeely, president of the National Association of Insurance and Financial Advisors, recently testified before the U.S. House of Representatives’ Committee of Financial Services that employees with workplace retirement plans need to be educated on the importance of “determining their risk tolerance.” Preserving Retirement Security and Investment Choice for All Americans: Hearing Before the H. Fin. Servs. Comm. (Sept. 10, 2015) (statement of Juli McNeely, President, National Association of Insurance and Financial Advisors).

The objective of this article is to inform readers of these important issues and outline the potential impact on securities litigation, arbitration, and regulatory enforcement. At the request of FINRA, I was asked to deliver a presentation on the topic to senior officials on December 9, 2015. This article shares much of what I presented to FINRA so that all concerned parties can evaluate the evidence on equal footing.

What Is Risk Tolerance?
The following definition of risk tolerance can currently be found on the FINRA website:

A customer’s ability and willingness to lose some or all of [the] original investment in exchange for greater potential returns.

This definition is theoretically flawed due to the fact that it does not make a clear distinction between “willingness” and “ability.” Risk tolerance is psychological and thus centers on emotions and feelings, which do indeed dictate a customer’s willingness to lose some or all of the original investment in exchange for greater potential returns. However, using the word “ability” in this context is inaccurate. A customer’s ability to take risk is dependent on the customer’s financial needs and circumstances: the expected returns required to achieve financial goals in combination with the customer’s capacity for loss.

As a subject matter expert, I am often called upon to review methodologies employed by potential clients and competitors to assess risk tolerance. Many of the assessment tools that I have evaluated over the years incorporate a time horizon as a sub-factor of risk tolerance. This is a crucial mistake because investment time horizon is a determinant of a client’s capacity for loss—not risk tolerance. Michael Kitces, “Separating Risk Tolerance from Risk Capacity,” Kitces Rep., Sept. 3, 2014.

The mere fact that an investor is willing to take a risk does not mean the investor should do so, especially in circumstances where the investor has a nice nest egg saved up and is on the verge of retirement. Significant losses can derail retirement plans, and older investors may not have sufficient time to recover from those losses. In this context, capacity for loss relates to the ability to take risk and not the willingness to do so. FINRA has indicated that the treatment of seniors will be a top priority in 2016. FINRA, 2016 Regulatory and Examination Priorities Letter (Jan. 5, 2016). This should give compliance officers and legal representatives further reason to take heed.

FINRA needs to clarify and rectify the description of risk tolerance accordingly by eliminating the word “ability” from the definition. This will help broker-dealers and registered representatives institute better practices. Furthermore, firms and registered representatives should make certain that they fully understand the assessment tools they are using and be wary of risk profiling processes that do not account for capacity for loss.

Global Regulatory Findings
Treating time horizon as a risk tolerance sub-factor can also lead to arbitrary scoring that can result in unsuitable advice. In the British study referenced earlier, regulators found that the scoring of risk tolerance questionnaires raised concerns due to the fact that many used “over-sensitive scoring or attribute inappropriate weighting to answers” and that “such flaws can result in inappropriate conflation or interpretation of customer responses.” In addition, many questionnaires used “poor question and answer options.” Likewise, “non-tool approaches” were deemed problematic for many of the same reasons. Financial Services Authority, supra.

Perhaps most troubling of all, the British study found that 9 out of 11 risk profiling assessment tools reviewed had weaknesses that “lead to flawed outputs.” When flawed outputs from assessment tools were then correlated to the corresponding consequences, the cause and effect became abundantly clear:

We reviewed the causes relating to suitability assessment failings from files previously reviewed by the FSA [Financial Services Authority] between March 2008 and September 2010. Of the 366 cases that we judged to have failed our suitability requirements, 199 cases did so because the investment selection did not meet the customer’s ‘attitude to risk’.

In the Canadian study that was also referenced earlier, 83 percent of the risk questionnaires were deemed “not fit for purpose.” Shawn Brayman et al., supra. Much like the British study, the Canadian study gave reasons that included “poorly drafted questions” and “arbitrary scoring.” Ninety percent of firms could not attest to whether their risk questionnaires were validated, which brings into question the issue of legal defensibility. As a result of these shortcomings, the paper’s authors recommended stronger regulatory action to provide better assurances that risk questionnaires are fit for purpose. While the British regulators found ample evidence of assessment tool failings, there has been little action to date to rectify the widespread problem in the United Kingdom.

Best Practices and Other Concerns
It is important to note that not all risk tolerance assessment tools are created equal. Regulators have a reputation for pointing out what firms do wrong but provide little guidance on how to do it right. Both the Canadian and British studies considered the use of psychometrics to be best practices, although the British study did not explicitly say so. Leading academic experts such as John Grable and Michael Roszkowski advocate the use of psychometrics, as do foremost practitioners like Michael Kitces, a prominent industry commentator, and Greg Davies from Barclays Wealth’s preeminent behavioral finance team. See Michael Roszkowski, John Grable & Geoff Davey, “Insights from Psychology and Psychometrics on Measuring Risk Tolerance,” 18 J. Fin. Plan. 66 (Apr. 2005); Michael Kitces, “Rethinking Risk Tolerance,” Kitces Rep., Sept. 2008. Here is what Dr. Davies wrote in a recent paper:

Risk tolerance is only stable when considered as a personality trait, which can be measured effectively using holistic psychometric scales.

Greg Davies & Peter Brooks, “Risk Tolerance: Essential, Behavioural and Misunderstood,” 7 J. Risk Mgmt. in Fin. Institutions, Nov. 2013.

That is not to say that psychometrics is the only way to effectively assess and measure risk tolerance. However, psychometric testing has a proven track record with some assessment tools having longitudinal data to substantiate the stability of risk tolerance scores throughout market cycles. See Geoff Davey, On the Stability of Risk Tolerance (June 2012). Psychometric risk tolerance questionnaires therefore provide a safe option if done properly.

Another concern is that many firms may not be assessing risk tolerance at all. According to a recent industry survey, 44 percent of respondents indicated that they did not use any type of risk assessment software to obtain information about and analyze investors’ risk tolerance. Whether that response is representative of noncompliance by firms or a result of regulatory enforcement failure is anyone’s guess, but it is certainly worthy of further investigation.

A similar pattern emerges in the case of workplace retirement plans. From my experience working in the market, few plan sponsors or investment advisors require plan participants to complete any form of risk tolerance assessment before making an investment recommendation. That deficiency raises obvious questions about duty of care liabilities, particularly if the Department of Labor’s new fiduciary rule is implemented. In FINRA arbitration cases, breach of fiduciary duty ranked number one in 2015 in the types of cases served. FINRA, Top 15 Controversy Types in Customer Arbitrations.

And if that is not enough to be worried about, consider the rise of digital investment advice in the form of so-called robo-advisors. Concerns have been raised over the extent to which robo-advisors go about obtaining and analyzing investors’ risk tolerance. Blaine F. Aikin, “Duty of Care and Robo-Advisors,” Inv. News, Oct. 11, 2015. It is reasonable to doubt whether robo-advisors are exercising due care by simply asking one or two risk tolerance questions before making an investment recommendation. According to the study by Britain’s Financial Services Authority, “[t]he fewer the questions—coupled with a possibility of misinterpreting an answer—the greater the probability is of making an inaccurate assessment.”

Most digital investment advice platforms were launched over the past few years and thus have not been tested through market cycles. It is therefore impossible to provide longitudinal data to see how well robo-advisor models hold up when investors experience profound and protracted market declines like those during the dotcom bubble and the global financial crisis. The same criticisms have been leveled at other risk tolerance assessment tools that have been adopted in the industry as of late.

What is known, though, is that the number of FINRA arbitration cases spikes dramatically after the onset of bear markets. FINRA data show that the number of arbitration cases filed between 2000 and 2003 rose around 62 percent and by more than 120 percent between 2007 and 2009—which represent the time periods of the Internet bubble and the global financial crisis, respectively. FINRA, Dispute Resolution Statistics.

It is difficult to say what percentage of those cases centered on suitability and “taking too much risk” because FINRA does not make that information public. One can surmise that the increase in cases filed is correlated with the factors given in the findings of the British review mentioned earlier, whereby regulators determined that more than half of suitability claims related to the fact that investment selection did not meet the investor’s attitude toward risk. Similarly, veteran securities litigators in the United States will likely have a pretty good idea of the numbers based on their own experiences over the years.

Due Diligence
The best way for firms and registered representatives to avoid litigation is to reduce exposure to potential liabilities. Having served as an expert and risk consultant in the BP oil spill litigation, I can attest to the fact that corporate culture often dictates what preventive maintenance actions organizations will take to mitigate their risks. A good place to start in this instance is to ascertain whether there is evidence to support that the assessment tool actually works. Here are a few due diligence questions for legal counsel to consider when evaluating the merits of a risk tolerance tool:

  • What testing methodology was used in the tool’s development?

  • Has the tool been evaluated by a third-party expert? If so, by whom?

  • Have the validity and reliability of the tool been established? If so, by whom?

  • Have there been any test/retest studies conducted to confirm the stability of tool results, particularly across market cycles?

  • What is the tool’s track record?

  • Who developed the tool and what are the developer’s credentials?

  • Is there a technical manual for the tool and scoring methodology?

  • Are there academic studies that support the tool’s integrity?

A more comprehensive checklist can be found in FinaMetrica’s Due Diligence Questions about a Risk Tolerance Test.

From a compliance perspective, it has only been necessary to demonstrate to regulators that risk tolerance information has been obtained and analyzed. Broker-dealers and registered representatives can essentially use any tool, tick a box, and then be done with it. That currently seems to be the preferred method across the industry. With FINRA now evaluating the methods that are used to obtain information about and analyze risk tolerance, there is a new dynamic to consider. The question that litigators will want to ask is whether the assessment tools in use are legally defensible. Depending on what side of the table you are sitting on, that could be viewed as either a threat or an opportunity.

Keywords: litigation, securities, risk tolerance, suitability, FINRA, Department of Labor fiduciary rule, duty of care, FINRA Rule 2111, investor psychology