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.
FACTORS INFLUENCING RISK PROFILE
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
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
HOLES IN THE SYSTEM
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
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.
ACTIVE VERSUS PASSIVE
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
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
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.