The investor profile is an essential component to understanding a client who has investment objectives. It allows an advisor offering investments or insurance including an investment component to determine the client’s personal and financial situation, their investment objectives, their investment time horizon, and their risk tolerance for each objective, as well as their investment knowledge.
The investor profile is not just based on a form that is filled out.
Of course, account opening and investor profile setup questionnaires are tools that help advisors know their clients and allow them to regularly save the required information to their files. However, it’s generally necessary to ask additional questions to obtain a sufficient understanding of the client.
Investor profile objective
The investor profile is the cornerstone for establishing the suitability of an investment recommendation.
Advisors must always ensure that the product is appropriate for their client. The client’s own perceptions of themselves may be incorrect. For example, just because a client confirms they are aware of the relationship between risks and rewards doesn’t mean they are actually willing to take risks.
Situations requiring an investor profile to be filled out
An advisor must create an investor profile for their client each time the client wants to make an investment or purchases an insurance product including an investment component.
In the case of spouses who want to make an investment together, an investor profile must be created for each of them. If they want to share an account and make joint investments, they must have the same risk tolerance for the same investment objective. This practice helps to detect any contradictions that the advisor might need to clear up or resolve to help the couple make the best possible return on their shared capital.
Investor profile content
Before recommending investments, an advisor must fully know their client, after etablishing their identity, so the product or the selection of investments they offer is appropriate for the client’s personal and financial situation. Effectively, the advisor must take reasonable steps to obtain the following information, at a minimum:
- Personal situation (marital status, age, number of dependents, etc.)
- Financial situation (current assets)
- Investment objectives (capital security, stable income, growth, tax reduction, cash assets, etc.)
- Investment time horizon for each investment objective
- Risk tolerance for each investment objective
- Investment knowledge
When it comes to a client’s external investments, if it is impossible to obtain reports containing information about these investments, the advisor must use their professional judgement to determine if they have sufficient information on the matter and determine if other elements need to be added to their client’s profile.
The advisor should warn the client that not providing sufficient information about their external investments could negatively impact the performance of their investments. The advisor must still have taken reasonable steps to obtain the information required from their client.
Specific details on the client’s personal and financial situation are addressed in the section Know your client.
Furthermore, the advisor must obtain a confirmation attesting to the accuracy of the information on their client. This can be done with the client’s signature (handwritten, electronic, or digital) or by adding notes in the client’s file regarding their instruction to modify their information.
Objectives indicated in the investor profile must be reasonable within the context of the client’s financial situation. By discussing with their client, the advisor can gradually help them turn their dreams and aspirations into financial needs.
The client probably has plans that are important to them, such as a home purchase, worry-free retirement, travel, paying for their children’s schooling, or simply reducing their debt. There are various types of client-investor investment objectives with the aim to achieve their projects…
- Capital security: the objective is to keep the capital intact, no matter the return earned.
- Stable income: the objective is to generate constant income from an investment portfolio.
- Capital growth: the objective is to increase capital. This is the profit earned (capital gain) at the time of security redemption. This objective generally involves a higher risk of capital loss, and therefore, a higher risk tolerance on the investor’s part.
- Tax reduction: whether an investor is seeking capital security, stable income, or capital growth, return taxation will have an impact on the investment option selected.
- Cash assets: the objective is to maintain the ease of accessing the invested capital, an important characteristic of a mutual fund.
This is the period during which an investor intends to invest their money and let it grow before using the amounts invested, in whole or in part, based on their objectives. The advisor must address each of the client’s projects separately to determine the specific investment time horizon for each one.
For example, the number of years between the time of investment and the planned date for purchasing a home is the investment time horizon for savings dedicated to this purpose.
The advisor must evaluate certain information to define an investment time horizon, in particular the client or beneficiary’s age, the amounts of money that the client plans to spend and for how long, and the withdrawals that they plan to make. The tool Know your client provides examples of information to include when calculating the investment time horizon.
The investment time horizon in this case is the number of years between the time of investment and the planned retirement date. Starting from the beginning of retirement, the investment time horizon must be re-evaluated by the advisor based on the various disbursement or other objectives. It is wise to confirm with the client the time they would like to retire and the standard of living they would like because recommendations made to them must take these into account. As a precaution, the advisor could advise their 57-year-old client who is 5 years from retirement of 15% return expectations…
The client wants to purchase a sailboat in their first year of retirement, which is in three years. However, they must take out a loan, for which they’ll need a down payment of $7,000. They will be able to pay off this loan in ten years.
The investment time horizon for this objective cannot be based on the loan repayment term; rather, it corresponds to the period between the time of the investment and the moment when they will need this money to purchase their sailboat, which is three years.
This is the most abstract concept of the investor profile. It is the investor client’s willingness to assume the risk of losing their savings as well as their financial capacity to face their portfolio losing value. Risk tolerance therefore includes an emotional aspect and a factual aspect.
Though the investment time horizon may influence risk tolerance, this is not an absolute rule. Effectively, even though we may think a client with a 30-year investment time horizon will generally be more inclined to accept more risk, by examining their situation closer and asking questions with concrete examples, the advisor may conclude that their actual risk tolerance is lower. This is especially because they wouldn’t want to experience a devaluation of their investment if, for example, they had to withdraw a certain amount in the short term for an emergency.
The risk tolerance of a client with a long-term investment time horizon and a high net worth and income will not necessarily be high, either, even though they might be able to withstand long-term market fluctuations. The advisor would be amiss if they stopped at this single financial capacity to absorb losses. They must focus just as much on the client’s emotional capacity to live with losses without worrying.
That being said, there’s nothing wrong with offering a leveraged loan to a person who is 60 years old. Even though this is considered a risky product, it may be appropriate if the client is fully aware of the risk and prepared to take it on, and if this strategy meets other suitability criteria.
The following items should be analyzed in depth to estimate a client’s financial capacity to absorb a loss:
- Their financial situation
- Personal information having an impact on their finances
- Their investment needs and experience
- The investment time horizon corresponding to each of their objectives
Many people don’t know what “market volatility” means. This is why it’s important for the advisor to evaluate their client’s risk tolerance before helping them make investments.
We don’t often see people worry about a sudden jump in their investment values, but what would happen in the event of a value drop? Gauging a client’s risk tolerance helps the advisor confirm that the investments offered will remain appropriate for their situation during both an increase and a decrease in the markets.
The client must know that an investment’s growth potential is as high as the risk. They will have to choose between lower risk and potentially more substantial gains.
The advisor must avoid projecting their own risk tolerance level on their client at all costs. They must also ensure…
- that the client fully understands the concept of risk tolerance
- that there are no inconsistencies between the client’s answers to the questionnaire to establish their investor profile and the results from their discussions on the topic
- that the client can indicate the level of loss they would tolerate, using concrete examples
Acceptable Level of Loss
To help the client have a better idea of the level of loss they are prepared to withstand, the advisor can use percentages. For example, they can offer them the choice of an answer that would start at 0% and increase by increments of 5% until they reach the level that they find acceptable. The exercise can be repeated with amounts of money that correspond to these percentages. Also, the advisor could use the Fund overview or simplified prospectus, or the information booklet, as appropriate, to feed the discussion on investment risk.
This will allow the advisor to prevent a potential conflict from arising between the client’s objectives and the actual investment challenges.
The Risk tolerance section of the tool Know your client gives examples of questions to ask to determine a client’s risk tolerance.
When investing, people sometimes make irrational decisions. These can be influenced by their emotions and assumptions.
Therefore, they sometimes tend to over-estimate their risk tolerance, in part because they would like to get higher returns.
An advisor’s advice is therefore especially useful to replace these assumptions in context and eliminate them, or at least decrease the effects on investment decisions.
Otherwise, a client who has over-estimated their risk tolerance could panic in the event of a market drop and decide to sell their investments at a very inopportune time.
In practice, a person may wish to purchase a product that does not correspond to their actual risk tolerance, in hopes of higher returns. Even in this scenario, the advisor is obligated to thoroughly evaluate their actual risk tolerance level before having them purchase a specific product.
Taking Things Into Consideration
Inconsistencies can also emerge between the client’s risk tolerance and their investment knowledge. For example, they may claim to have a high risk tolerance, but have little investment knowledge and experience. They may not understand what the risk of losing part of their capital actually means. The advisor must then help them take things into consideration.
Because they know their client well, the advisor is able to help them determine their risk tolerance. The investor profile questionnaire is a good guide—not only to establish this profile, but also to detect inconsistencies between the client’s answers and the details collected by the advisor during their discussions.
Correctly evaluating a client’s investment knowledge is essential. This practice is closely linked to the duty to inform, because this duty must be adapted as a result.
If the client has limited knowledge, it may be difficult for them to understand the advantages and disadvantages of products offered by the advisor.
Some financial strategies and products present a complexity that requires a higher level of knowledge about investing. This is why it’s essential that the advisor ask the questions that allow them to evaluate the level at which the client is located. In doing so, they can both adjust their expectations and avoid dissatisfying their client, who probably had unreasonable return expectations, and who must now reflect on the financial consequences that may ensue.
For example, not everyone knows enough about finance to distinguish between the maximum deductible for RRSPs and unused contribution room. Regardless of their age, if a client is not able to understand the nature of the recommended strategy and its associated risks, the advisor must reconsider the appropriateness of this strategy, even if all the financial situation components are favourable for it.
Among the various ways to evaluate a client’s investment knowledge, an advisor can…
- ask them open-ended questions with the goal of ensuring that they know and fully understands the details of investments, and their potential for loss in particular (not limited to closed questions on questionnaires)
- confirm the information from the form by verifying out loud with them that the knowledge they confirm to have on paper is not theoretical
- take their personality into account to know how to address the topic with them
Financial literacy scales may also help the advisor estimate a client’s level of understanding. For more details on this topic, see the Financial literacy section of the Survival guide for productive discussions.
If the client confirms to have a good understanding of investing, the advisor should determine whether this includes both practical and theoretical knowledge… For example, a recent university graduate in finance may have a good theoretical understanding of it, but not know how they would react if market fluctuations were to affect their personal portfolio. The advisor must therefore verify the client’s practical background with various types of investments.
Finally, if the client has limited knowledge, the advisor must provide them with more explanations and take the necessary time to estimate the suitability of the strategy and products to recommend to them.