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RISK PROFILING – IS IT WATERTIGHT? (Richer Life 31 August 2004)

Matching an investor’s risk profile with the appropriate investment has always been a cornerstone of the investment advisory process. But it’s also the hardest thing to do because while most people accept that risk is a part of life, they spend most of their life trying to avoid it.
When it comes to investments, however, most investors do realise that they do need to take on some risk to achieve their financial goals – and its up to their financial adviser to determine how much they can bear.
With effect from 1 October this year it also becomes a legal requirement in terms of part 8 (1) c of the Financial Advisory and Intermediary Services (FAIS) General Code of Conduct which states: “A provider must, prior to providing a client with advice – identify the financial product or products that will be appropriate to the client’s risk profile and financial needs”
That shouldn’t be too much of a problem because there are plenty of risk profile questionnaires around and it is standard practice for clients to go through some form of screening process before an investment is placed. But doubts are starting to be raised about their accuracy and the perfect solution doesn’t seem to be forthcoming.

Risk profiling questionnaires come in various shapes and sizes but most include the factors listed in the table. The rationale for calculating risk appetite like this is simple – if you have a big buffer to absorb unexpected losses then you can afford to take risks. So if you are a young, healthy, high-earning person with few dependents then you can make up for any losses in years to come. However if you are old, of ill health and totally dependent on your investments to cover you and your dependents’ living costs then there is very little margin for error.

The different factors influencing risk profile are usually given different weightings so that, for example, the age factor might contribute towards 35% of the final risk profile, whereas the acumen factor may only count for 8%.
Once an investor has answered all of the questions in the risk profiler, the numbers are all added up and the resulting total will indicate where the investor fits on the investment spectrum. But how accurate are the results?

When viewed in its entirety, the general rationale behind the standard risk profiler is good. But if you examine some of the factors in isolation certain traditional assumptions beg proper explanations.
Take financial acumen. The conventional model would have us believe that investors with more of it should take higher risks than those with less of it.
The argument goes that people who understand investment markets are likely to be able to endure more volatility than those that don’t. But does this mean that an accountant should automatically take on more risk than a plumber?
Or what about net worth? Surely the investor who is lucky enough to be very well off can more easily afford to adopt a “stay rich” strategy as opposed to a “get rich” strategy compared with somebody building up their wealth.
And how do you measure wealth anyway? One of the more popular risk profilers asks whether your savings are “equal to or greater than five times your annual salary”. If you answer “yes”, you get maximum points for your ability to stomach high risk. But recent consensus in the retirement industry is that to retire comfortably at age 65 the rule of thumb is closer to a capital requirement of 15 times your final annual salary. That means a person about to retire with capital of only 5 times salary is seriously under-funded and should not necessarily be taking on maximum risk.

That doesn’t mean we should dispense with risk profilers altogether. Their intention is good and they are certainly better than no screening at all. But in many instances they are too generalistic and, as a result, certain clients can fall right through the cracks.


Whatever the risk profiler chosen, most advisers these days protect themselves by getting the client to sign the document upon completion and filing it for safekeeping with all the other client records. Indeed, with FAIS around the corner, all advisers should be doing this. This documented evidence serves as a safeguard for the adviser should future disputes arise when investments go awry and it provides evidence that the adviser did their job properly.
But given the shortcomings of the available risk profile questionnaires, has the adviser done their job properly by accepting their results as fact?
By investing strictly according to a signed risk profiler, the adviser covers him or herself, but this may not always be the best advice for the client. Often the path of least resistance is to invest according to the risk profiler, but at some point surely the adviser should take an active role rather than a passive role.
Take the issue of “financial personality types”. In the US, a whole industry has sprung up to pinpoint your relationship with money. The questionnaires are extensive, designed by psychologists and after completion clients are identified as falling into categories like “high rollers” or “safety players”. But if a naïve investor who clearly cannot afford to take risk comes out as a “high roller”, is it not the adviser’s responsibility to urge them to adjust their personality type? Ben Fraser, head of personal financial planning at Momentum, has strong views on this topic and believes that the character of an individual has nothing to do with a sound financial strategy. In fact, he states, “a client often needs to be protected from their own traits”.
PSG Konsult director of products and training Anton Swanepoel has concerns that section 8 (1) c of the FAIS Code of conduct may even be disadvantageous to the client if applied indiscriminately. Swanepoel has conducted a rigorous survey amongst top financial advisers in the industry and found that prevailing market sentiment has a huge effect on the risk profiling of investors.
Nine out of ten times investors answer “aggressively” in strong equity markets and “conservatively” in depressed markets. This clearly encourages a herd mentality, which is a doomed strategy for any sound long-term investment. Based on Swanepoel’s research he believes that “in years ahead the current risk profiling model will be found to actually encourage negligent advice.”
So proper financial planning, it seems, needs to include an element of client education. Indeed, coaching the client and advising the client are often linked at the hip and advisers of the future will need to actually “give advice” rather than just filling in the forms and going through the required motions.

Not everybody in the industry has overlooked the pitfalls of the standard risk profiling approach. One of the biggest blind spots in the traditional process is that the risk profile of an investment itself changes with time. Consider an investment with three months left to run versus one with seven years left to run. The actual investor’s risk profile may not have changed, but any adviser worth their salt will tell you that the investment with three months left to run needs to be protected against short-term volatility.
Momentum recognized this need and launched their LifeCycle fund range last year to specifically cater for an investment’s life cycle. Four core funds are used – the Accumulator, Builder, Consolidator and Defender. Investments start out in the aggressive Accumulator fund but are automatically switched into increasingly conservative portfolios as the investment approaches its maturity date.
Another company that has another way of profiling risk appetite is acsis (formerly ipac). Recognising the flaws in the traditional process, ipac asks the question: “Why should two investors, each with the same assets and risk profiles but totally different objectives, be given the same investment strategy?” They turn the traditional planning process on its head starting, rather, with the individual client’s lifestyle objectives and working backwards from there.

Ipac’s approach has worked for many of its clients but is not without its detractors. One criticism of this model is that there are no checks and balances to see if the investor should be aiming at the lifestyle they desire. After all, we would all like to live in the lap of luxury but does that mean that we must all go for aggressive investment strategies?

The bottom line is that no standard risk selection process can offer the perfect solution. Not all clients slot neatly into pre-defined “one-size-fits-all” categories. Nothing can replace getting to know a client individually - and invariably the best way to achieve this is for the client and adviser to spend time together. Ultimately this is very good news for financial advisers, as they are not likely to be replaced with on-line computerized risk profilers, no matter how sophisticated these become.

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