21 November 2007
By Johan du Toit
The recent Twenty20 World Cup cricket tournament was a wonderful example of the power of change. Not even five years ago, who would have thought that there would be cricket matches played with dancers on the boundary rope, fireworks going off at exciting moments and blaring music being played at every possible opportunity? Never mind the fact that a whole cricket match could be played in just three hours!
When it comes to financial planning, there is one practise that we really need to change to improve the experience and outcome of all players in the industry. This practise is commonly known as Risk Profiling, which is seen as a method to help financial planners understand their clients better, and for clients to understand themselves better. The problem is that many people view Risk Profiling as a sacred cow, and to challenge this is probably more radical than suggesting that a cricket match be played in three hours!
The extent to which Risk Profiling is a sacred cow is demonstrated by the FAIS Act’s General Code of Conduct, which guides the provision of financial advice. It states that “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”. In effect this is telling us that to comply with the rules of the game, a financial planner needs to do a Risk Profile of their client.
The FAIS Ombud, Charles Pillai, has also gone on public record as saying, “When considering a complaint, the Ombud has to conduct an investigation. He will look at all avenues of non-compliance or wilful negligent conduct on the part of the FSP or representative…this may include failure to give appropriate advice which may be manifested by the failure to do a risk profile.”
What is risk profiling?
Given what the rules and the umpire have to say, it would seem that the process of Risk Profiling is a very sensible thing to do in the game of financial planning. Why then the call to commit sacrilege?
Before answering this question, let’s look briefly at the process of risk profiling. In essence, it requires a client to complete a questionnaire, which seeks to understand their attitude towards, and perceptions about risk.
Points are allocated for each answer and the total points scored will indicate whether the client’s risk profile is on the one end of the scale, “Conservative”; “Aggressive” on the other end, and “Balanced” or a permutation thereof in between. Usually a risk profile questionnaire will have up to five or six different profiles into which clients can be categorised. Once a client’s risk profile has been determined, it is possible to match an investment to the client’s risk profile.
The fundamental problem is that a client’s attitude to, and perceptions of risk are being measured, and these attitudes and perceptions can change. For example, when investment markets rise people feel more optimistic, and when they fall people feel more pessimistic. In addition, whilst there may be different categories of risk profiles, each person has a different understanding of what a category might mean to them.
To demonstrate this, Xchange Solutions recently conducted research into individual understanding of risk profiles by surveying 231 clients of a financial planning business, countrywide. In the survey, clients were simply asked to identify their own risk profile out of three options: aggressive, balanced or conservative. They were then asked to indicate what annual return they would expect from their investments over the next five years.
How risky is risky?
The responses showed that 29 percent of respondents saw themselves as conservative, 65 percent as balanced and 11 percent as aggressive. However, within each category the return expectations of each client were radically different. In the conservative category, the lowest expected return was three percent pa, and the highest was 35 percent pa, with an average expected return of 12.5 percent.
The balanced category had a lowest expected annual return of five percent and a high of 55 percent, with the average being 16.6 percent, and in the aggressive category the low was 12 percent, the high was 50 percent and the average was 23.4 percent. Apart from the enormous range of expectations within each category, there were obviously major anomalies between categories, where people who classified themselves as aggressive had lower expected returns than those who classified themselves as conservative.
This research has been replicated with different groups over the past three years and has consistently highlighted the dramatic flaws in risk profiling as well as the unrealistic expectations of most investors. In this survey the unrealistic expectations are clearly demonstrated by the average expected return of the conservative category, namely 12.5 percent, which is equal to the long-term (100 years) return of South African equities; the highest risk asset class!
There are other problems with risk profiling. Questionnaires are either too simple or too general, or both. But it is at the first premise of risk profiling that the process is flawed, the attempt to measure a client’s risk profile. The key to successful investment decision-making is not to understand the risk profile of a person, but to understand the risk of an investment. As can be seen, a person’s risk profile is a moving target. In contrast, we are able to quantify the risk of a particular investment to determine the likelihood of an investment return being achieved or not.
This can be done because each major investment asset class has unique risk and return characteristics, which can be assessed. These can be explained to a client and the client can decide how much investment risk they are prepared to take on. If a client is not comfortable with the amount of risk, the only thing they can do is revise their return expectation, because the first principle of investing is that risk and return are related.
In contrast, there is no relation between an investor’s risk profile and return, which is why risk profiling should be consigned to the scrapheap of unhelpful and potentially dangerous investment tools. And when this happens, we could perhaps have a celebratory party with dancers, fireworks and blaring music. Alternatively, we could just go and watch a Twenty20 cricket match.