As we discussed in a previous article that early in the financial planning process there are two vexing questions which a planner needs to attempt to establish – the first being the client’s risk profile and the subject which was previously covered ‘longevity’. In that article readers were directed to a useful website www.mylongevity.com.au.
By definition risk is something that is inherent in any form of investing, be it equities or cash, all assets classes carry a form of investment risk. For example, cash carries inflationary risk which is the risk of real capital erosion or equities the risk of capital loss through bankruptcy or unrelated equity market factors.
The importance behind risk profiling is to correctly align the client’s appetite and capacity for risk. While higher returns are desirable, these returns are often accompanied by a higher level of volatility. Thus a number of factors must be taken into account when investing money. Liquidity, time horizon, income needs, age, and objectives will all form part of the risk profile of the client. Generally, a client with little or no need for liquidity or income and a long investment horizon will be able to take on greater risk than compared to a client with a short time frame and need for easy access to the funds. Importantly, a client’s attitude towards risk must be considered. In reality, while two individuals may display virtually identical characteristics, their attitude towards and tolerance of risk may be totally different, requiring a different investment approach.
“Investment suitability is the foundation upon which good investment advice is built. Not only must the investment be suitable with regards to the investor’s goals (risk required) but also with regard to the investor’s risk capacity and risk tolerance.
Ensuring that investors receive investment recommendations that meet their needs requires sound process, robust tools and advisory skills. This is a blend of art and science. The science lies in the tools the advisor uses. The art lies in the advisor’s ability to use the tools effectively, to work collaboratively with clients to obtain an in-depth understanding of their needs, to assist clients in resolving mismatches by identifying and explaining alternatives, and to guide the decision-making process”
Geoff Davey, Cofounder & Director Finametrica
In considering risk and risk profiles investors are often thrown into confusion, which to no large part is the result of terminology, aligning the purpose of the risk profile analysis to the range of investment decisions, purposes and objectives.
With this in mind it may be useful to put some definition around this terminology:
Linking investor goals to the risk required.
This requires an advisor to be adept in asking searching questions about their client’s expressed goals, current and anticipated income and expenses, and current and anticipated assets and liabilities. Too often goals are expressed in a hazy fashion which may fit the particular conversation but do not deeply express the client’s true objectives. For example: ‘I would like to retire at 60 to pursue by passions.’ Yes an investment portfolio can be built around such a goal – but what is the real purpose of goal and what could be the real outcomes should it be achieved?
Accessing risk capacity.
This is the extent to which an individual’s financial plan can withstand the impact of unexpected (negative) events.
For the planner it is simple to construct certain outcomes which assume certain rates of return – however unfortunately history shows that these projections are often wrong, generally due to over optimism. To mitigate against such outcomes the portfolio should be stress-tested by projecting a range of investment returns and life events. For example in the current economic downturn what would be the effect of early forced early retirement – this is not only economically but also the mental effect of such an event. Are there strategies which could be put in place to enable the client to handle the situation?
Assessing risk tolerance.
Risk tolerance is a psychological measure. It is how the investor feels about taking risk. Where does the person strike the emotional balance between investment return and risking an unfavourable outcome? In many respects this psychological assessment is the new frontier with respect to risk profiling. A frontier which organisations such as FinaMetrica have been pursuing for many years and have gained traction in many developed markets around the world.
In conclusion the science and art of risk profiling really comes into focus at times of market corrections because the natural reaction is concern or even panic. One only needs to look back to 2008 to observe the reactions of many investors who moved out of equities into cash, some of these investors have continued to maintain defensive portfolio and missed an extraordinarily strong bull market. The message in all of this is to be certain of the outcomes you are seeking to achieve, construct an investment portfolio to meet this need then stay with your decisions even when markets take a tumble as inevitably happens.
The investment cliché to support this strategy is that ‘it is time in the market and not timing the market’. The latter is a fool’s game which very few have the skill to be successful.