June 22, 2021

The perils of risk profiling

A note to financial advisors and their clients from Craig Turton, VP Wealth at Emperor Asset Management

It’s a client request that’s all too familiar to financial advisors: “I want the highest return in the shortest time possible with the lowest level of risk.” Wouldn’t it be lovely if we could provide that? Unfortunately, these are separate requirements are not compatible with each other, and it’s up to us as advisors to educate investors to this fact.

We need to be having conversations with our clients about the relationships between returns, time horizons, and risk. We need to identify why the client wants quick returns. Why is s/he only investing for a short period? Yes, it’s possible to chase high returns in the short term, as long as the client understands the downside. (A better solution for this type of client might be trading… but that’s a different discussion in itself.)

Whatever the outcome, all advisors are required to talk about risk with clients and ensure they understand the pros and cons associated with their investments.

One of the tools we have at our disposal is risk profiling, which we use to determine a client’s appetite for risk, or “risk personality”. And while it is a useful exercise, it should not be applied in isolation. Any needs assessment must take all aspects of a client’s investment requirements into consideration.

Too many risk profiling tools only look at risk tolerance, which is essentially how much risk a client can stomach. But there are actually three areas that make a financial needs assessment valuable:

  1. What level of risk in the investment is required to achieve the client’s objectives?
  2. How much risk can a client afford to take?
  3. How much risk is a client willing to take?

The above points will also give an investors good insights into their investment behaviour when markets shift, either up or down.

If the assessment encompasses these three elements, I believe it will be of value.

Risk profiling is, of course, also a compliance issue and needs to be carried out in conjunction with all other regulatory requirements. If the record of advice includes the intention of the investor, what his/her current investments look like and the goals surrounding any new investment, then the regulator will be satisfied. The advisor would need to disclose to the client the level of risk or volatility they are recommending and why it suits them.

At the end of the day, risk profiling is intended to protect the investor, who often does not understand the differences between shares and cash, for example. There needs to be a check in place to prevent an advisor from putting a client’s funds into something they do not understand and where they cannot actually afford the risk.

For example, a 70-year-old who has only R2 million to live off for the rest of her life should not be invested in a pure equity structure. The volatility will be too high for her and the funds could deplete a lot faster when compared to a more balanced portfolio.

On the other end of the scale we have a 25-year-old wanting to invest for his retirement in 40 years’ time. Say, for example, his risk profile shows he is a conservative investor. The worst thing here would be to follow the risk assessment and put him in cash. Due to the time frame, he should be in a predominately equity-based investment.

Our sister company, EasyEquities, recently undertook a risk scoring exercise on its 800 000 clients. The sample group was 25% female, 75% male, with an average age of 33. The mean risk score was 67.9 out of 100. This shows us that EasyEquities clients are comfortable in a moderate to high risk investment structure. These are usually funds with more exposure to shares and property, which would generally be your growth assets, but with more volatility in the shorter term.

EasyEquities clients are DIY investors, which means they choose the structure of their own investments. The risk score gives them an indication as to whether or not they are investing according to their own score. The choice is up to them.

Risk-based investing in an intermediated environment, however, is a different story. Any investment based solely on a risk assessment is, in my opinion, unsound. We should rather be helping clients to invest according to their needs and goals. My feeling, therefore, is that purely risk-based investing won’t get the desired result for the client and should be avoided.