Risk management in wealth management

How to understand the risk management strategy in wealth management?

“Risk” can be defined as a “deviation from the desirable result”. To properly manage risk and ensure ongoing managing risk efforts in wealth management, experts use risk management strategies. These strategies are perceived as the process of the identification and analysis of risks connected with capital investment, emphasizing the importance of managing risk as an inherent part of investing.

The goal is not only to identify but also to mitigate risk through various strategies, aiming at minimizing losses which could occur in connection with using different investment products. Mitigating risk involves:

• diversifying investments,
• understanding risk tolerance,
• and employing specific risk management strategies to reduce the impact or likelihood of potential risks.

Also, another term, i.e., risk tolerance, is connected with risk identification.

Specialists offering the wealth management service usually create a risk profile for every customer. In this way, they may choose the products matching the investment objectives of the customer from the pool of available investment instruments and adapt them in terms of the risk the customer is willing to incur.

The risk tolerance is frequently connected with the age and liquid capital of the investor. To simplify, you may say:

• the younger the investor is, the more prone they are to risky behaviors.
• the wealthier customer will be able to accept higher risk.

This makes risk management important in achieving investment objectives, as it requires individuals to identify, analyze, and make important decisions about uncertainty to reach their goals while dealing with associated losses.

What are the financial planning and wealth management risks?

Wealth management (comprising e.g. investment advisory services and help multiplying deposited assets) entails risk, including financial risks. The major risk factors related to wealth management defined by the experts include:

• Potential losses. They refer not only to the situation which may result from wrong investment decisions. For example, customers classified into HNW (High Net Worth) and UHNW (Ultra High Net Worth) group frequently own collections which are easily overseen when buying insurance. They include e.g. luxury clothes or goods,
• Incorrect estimation of the customer’s investment capacities. Investment advisors must base on specific data and not on the beliefs of customers who may underestimate or overestimate their investment capacities without a detailed analysis,
• Sudden changes of the agreed wealth management plan. Customers not always stick to the agreed investment schedule which may result in losses higher than the initially accepted ones,
• Market risk. This involves the risk of investment loss due to changes in market conditions, affecting the overall performance of investments,
• Operational risk. It includes risks arising from day-to-day business operations, such as failures in internal processes, people, and systems.

Also, the misunderstandings between the advisor and the customer may appear in the course of cooperation. Specialists managing wealth may encounter a situation when the customers insist on investing funds in a high-risk instrument and then try to transfer liability to the advisor. This is why all arrangements with the customer should be documented.

Also, the investment risk should be mentioned. The investors are exposed to:

• FX risk. It is closely connected with the FX rate fluctuations. Some investors may hold financial resources in different currencies, while other earn on the FX rates.
• Inflation risk. It refers primarily to the investors who choose bonds or shares, i.e. investment instruments considered to be low-risk and also bringing relatively low profits.
• Systematic risk. It is understood as general economic factors beyond the investor’s control which means they are not able to protect themselves from it efficiently.

To identify all wealth management risks, including potential risks, a thorough analysis is required. The developed investment plan should protect the customers’ wealth as much as possible and be adapted to their needs and expectations.

Risk management in wealth management versus legal regulations

Technically speaking, the risk management process in wealth management is crucial for adhering to legal regulations and ensuring a structured approach to managing risks. This process involves a system of people, processes, and technology that enables organizations to establish objectives aligned with values and risks. It emphasizes the importance of risk identification, risk analysis and assessment, and risk mitigation and monitoring. These steps are vital in protecting the business from uncertainty and increasing the likelihood of continuity and success. From this perspective, risk management in wealth management can be considered through:

• legal regulations imposed on companies specializing in financial advisory services,
• looking for solutions to minimize the risk.

Much importance is attached to the customer protection on the European market. There are the KYC (Know Your Customer) and TCF (Treating Customers Fairly) regulations, to mention just a few. Also, the MiFID II (Markets in Financial Instruments Directive) is in force in the European Union. This directive, adopted by the European Parliament in 2014, solidified the investors’ standing, ensuring they receive a set of information from the advisor. If the service refers to the investment advisory, the customer must be informed about:

• whether the advisory services are provided independently,
• whether the advisory services are based on a broad or a limited analysis of various financial instruments,
• whether the investment company provides the customer with a periodic liability assessment concerning the financial instruments recommended to them.

The customer must also be warned of the risks connected with investing in particular instruments and possess comprehensive knowledge of the costs they will incur (this refers both to the costs of financial services and of the ancillary services).

Risk management in wealth management versus software

Wealthy customers usually demand comprehensive solutions from companies offering the wealth management service, emphasizing the importance of financial planning in managing assets, providing financial advice, and helping clients grow and preserve their wealth. In practice, they expect the specialists to indicate the risks concerning their wealth and propose relevant solutions that include effective risk management strategies for achieving financial security and wealth growth. To minimize the wealth management risks in the investment category, the investment portfolio is diversified as the primary measure, which is a crucial part of a comprehensive risk management strategy aimed at risk reduction. Experts list three methods of portfolio diversification:

• Investment objective and horizon. This method consists in using short- and long-term investment instruments.
• Assets. Investors should have different investment instruments in their portfolio, including e.g. shares, precious metals, or government bonds. What is more, it is worth using asset allocation. In this strategy, the person managing the investment portfolio can relocate assets from one account to the other. This is aimed at multiplying the capital, using the current market trends,
• Market diversification. The investor should invest not only on the local, but also on foreign markets. This refers particularly to the customers in the above-mentioned HNW and UHNW groups.

To facilitate risk management in wealth management, banks and advisory companies use cutting-edge software as part of their risk management strategies, including diversification and risk reduction goals. Automating some activities enables the elimination of calculating errors which could be detrimental to the financial results. Cutting-edge software enables minimizing risk. For example, the robo-advisory channels, which are more and more popular with customers, may support the investor (to a limited degree) when their personal advisor is not available.

Comarch Wealth Management software enables the collection of many types of data which may become a starting point for many later analyses. Comarch software composed of numerous modules was designed to support advisors when developing customized investment strategies for customers on the one hand and to give a comprehensive view of the investment portfolio to the customers on the other. Consequently, the customer service (including the aftersales one) can remain high quality which contributes to building relationships between the investor and the advisory company or the bank.

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