GUIDANCE NOTE

GN 0 Summary and Purpose of Guidance Notes

As at: 1 October 2011

Guidance Notes are issued by the Institute to: - aid members in the interpretation of the Institutes Practice Standards, Rules of Conduct and other requirements - aid Members with the interpretation of legal requirements (such as the Financial Advisers Act and Code of Professional Conduct) and relevant court decisions - include practical ideas to aid compliance; - identify best practice; and - introduce business tools to assist in compliance with professional obligations. The Notes are designed to address key areas of Member practice which identify common issues or where significant risk occurs, as highlighted by:- regulation and legislation - court cases Unlike other Institute documents such as Practice Standards, Guidance Notes are not enforceable by the Institute under its Bylaws or any other entity. Guidance Notes are issued following a full consultative process overseen by the Professional Practice Committee. Any Member may make suggestions on changing an existing Guidance Note or proposing a new Guidance Note. This should be made to National Office (info@ifa.org.nz). Full details of the process are contained in the Policy Document for Member Guidance.

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GUIDANCE NOTE

GN 02 Investment Risk Profiling

As at: 1 October 2011

Legislative requirements
1. The Code of Professional Conduct, which governs all Authorised Financial Advisers, says: Code Standard 6: An AFA must behave professionally in all dealings with a client, and communicate clearly, concisely, and effectively. Code Standard 8: An AFA is only required to determine suitability under this Code Standard based on the information provided by the client and information otherwise known to the AFA. However, an AFA must make reasonable enquiries to ensure the AFA has an uptodate understanding of the clients financial situation, financial needs, financial goals, and tolerance for risk, having regard to the nature of the personalised service being provided. 2. The Financial Advisers Act prescribes: Section 33. Financial adviser must exercise care, diligence, and skill (1) A financial adviser, when providing a financial adviser service, must exercise the care, diligence, and skill that a reasonable financial adviser would exercise in the same circumstances.

Institute guidance
This Guidance Note is for the use of all Institute members regardless of their regulatory status (RFA, AFA, QFE adviser or none of these). If you are providing an investment planning service, you should use an adequate process when determining the clients investment risk profile. If you are making recommendations on one or more investment products, even if these are not in the form of an investment planning service, then you should also ensure you take reasonable steps to ensure their suitability for the client. CLIENT UNDERSTANDING 1 Most unsophisticated clients do not view risk in statistical terms. Concepts like standard deviation of expected returns and upside risk may not be useful to them. They are also likely to feel a loss far more strongly then they feel a comparable gain. 2 Does the client understand the terms and words used? Do you and your client have the same understanding? Some words have different meanings to different people and you must be clear what you mean when you use particular terms. Words and terms that you

should be particularly careful with include risk, volatility, balanced, aggressive. You should also be careful in your definition of short term, medium term and long term. 3 An unsophisticated client cannot decide the appropriate level of risk to accept. You should take steps to assess your clients level of sophistication and tailor your advice accordingly. 4 Does the client understand the relationship between risk and reward? It is essential that you understand the client's level of financial literacy and to the extent possible, educate clients as to the relationship between risk and reward. 5 Your obligation goes beyond communication to include challenging a clients view of their risk tolerance if you believe it is incorrect and could lead to inappropriate decisions. 6 Does the client understand the risk of default? In addition to assessing a client's attitude to risk, you should also take into account the client's capacity for loss. As clients generally react more to losses than to gains, you should also ensure a client is comfortable with both the likelihood and the potential impact of any loss. 7 Are there any other relevant factors? Questions you should consider include considering - whether the client is a sophisticated or novice investor; - the needs for capital and income of the client; - the time scales over which the investments will be made; - the possibility of early access to funds. USE OF RISK PROFILERS 8 Risk profiling tools are a useful aid in helping you and your client to understand their risk profile. However they are not sufficient on their own. Also, the results that a risk profiler produces may not necessarily be valid. With each client you should consider if the risk profile tool is appropriate and if the result that tool produces are valid. PROCESSES AND DOCUMENTATION 9 It is unlikely to be sufficient for a client to complete a risk questionnaire and sign off on a risk profile. You must have processes in place to consider whether the risk profile is appropriate for a particular client. Such processes are likely to include, supplementary questioning of the client; details on the recommended risk profile that the client could consider to confirm that they are comfortable with the risk profile identified; highlighting the risks that could reasonably be associated with a particular risk profile if implemented. 10 The analysis followed with each client should be documented in your records for that client. Note relevant factors outside the risk profile that you have considered. 11 If the client does not accept your risk profiling assessment, you must document that rejection and possible implications by producing a document containing your recommendation and an acknowledgment that the recommendation has not been accepted, preferably signed and dated by the client, and retained in your file.

12 You should describe in your ABS the process you use in assessing investment risk tolerance and capacity including how your use risk profiling tools. 13 The investments that you recommend should align with the results of your risk analysis.