Re­ly­ing on risk pro­fil­ing can be dis­as­trous for your fi­nan­cial health

An­drew Bradley, the chief ex­ec­u­tive of fi­nan­cial plan­ning com­pany ac­sis, told the ac­sis/per­sonal Fi­nance Fi­nan­cial Plan­ning Club’s last meet­ing of 2011 that it is un­wise – and po­ten­tially un­healthy – to pri­mar­ily base in­vest­ment de­ci­sions on your ap­petite

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Mak­ing in­vest­ment de­ci­sions based on your risk pro­file can have dis­as­trous fi­nan­cial con­se­quences, An­drew Bradley says.

Many fi­nan­cial ad­vis­ers use stan­dard risk pro­file ques­tion­naires to as­sess your ap­petite for risk, and, based on the out­come, de­ter­mine your in­vest­ments ac­cord­ing to their risk level, Bradley says.

The ques­tion­naires ask, for ex­am­ple, what your age is and how long you plan to in­vest. They also typ­i­cally ask how you would feel if you lost a par­tic­u­lar per­cent­age of your in­vest­ment, he says.

Your an­swers add up to a score that de­ter­mines whether you are an ag­gres­sive, mod­er­ately ag­gres­sive, mod­er­ate, mod­er­ately con­ser­va­tive, con­ser­va­tive or risk-averse in­vestor.

These risk pro­files are then matched to var­i­ous as­set al­lo­ca­tions, with a lower ex­po­sure to riskier as­set classes, such as listed shares (eq­ui­ties) and listed prop­erty, for the more con­ser­va­tive in­vestor, and a higher ex­po­sure to these as­set classes for the more ag­gres­sive in­vestor, Bradley says.

The more con­ser­va­tive in­vestor is likely to be ad­vised to have a higher pro­por­tion of his or her in­vest­ments in less risky as­set classes, such as bonds and cash, whereas the more ag­gres­sive in­vestor may be ad­vised to have a lower ex­po­sure to these as­set classes, Bradley says.

But if you use your risk pro­file to de­ter­mine your in­vest­ment strat­egy, you are likely to face a rude awak­en­ing later in life, he says.

The rude awak­en­ing will be when you re­alise that your in­vest­ments will not meet your needs, and you will be forced to make sig­nif­i­cant changes to your life­style.

Your rude awak­en­ing could be at re­tire­ment, when you re­alise you will have to scale back your life­style be­cause you have saved too lit­tle, or some time be­fore re­tir­ing, when you re­alise you will have to cut your ex­penses and save more to main­tain your life­style in re­tire­ment.

The most im­por­tant fac­tor in de­ter­min­ing your as­set al­lo­ca­tion is your needs, based on the sav­ings you have, the sav­ings you need, and when you will need those sav­ings, Bradley says. Your needs de­ter­mine the re­turn you will re­quire to gen­er­ate the sav­ings you need, and this in turn should de­ter­mine your as­set al­lo­ca­tion, he says.

Once you have de­ter­mined your in­vest­ment strat­egy in this way, you must con­sider the risks you will face by adopt­ing that strat­egy and de­cide whether you are com­fort­able with them, Bradley says.

A ques­tion of­ten in­cluded in risk pro­file ques­tion­naires is what in­vest­ment ex­po­sure you have had in the past to eq­ui­ties, listed prop­erty, bonds and cash, Bradley says.

An in­vestor who has only ever in­vested in cash is re­garded as a con­ser­va­tive in­vestor, Bradley says, whereas one who has had ex­po­sure to eq­ui­ties or listed prop­erty is re­garded as an ag­gres­sive in­vestor.

But the ques­tion takes no ac­count of your needs, he says. Your past ex­pe­ri­ence may not have been ap­pro­pri­ate to meet those needs.

Sim­i­larly, it is wrong to as­sume that an older, wid­owed wo­man must be a con­ser­va­tive in­vestor, whereas a younger man must be an ag­gres­sive in­vestor, Bradley says.

The older wo­man, for ex­am­ple, may need to in­vest more ag­gres­sively in or­der to avoid de­plet­ing her re­tire­ment sav­ings be­fore she dies, and be­cause she has no other sources of in­come, he says.

The younger man may have in­her­ited money and may not need to work, but he may be very scared of los­ing any of the money he in­her­ited. He can af­ford to in­vest more con­ser­va­tively, which will give him the peace of mind of know­ing that he will def­i­nitely have enough to sup­port his life of leisure in the fu­ture, Bradley says.

UN­RE­AL­IS­TIC EX­PEC­TA­TIONS

Over the past year, ac­sis sur­veyed more than 1 000 mem­bers of the Fi­nan­cial Plan­ning Club around the coun­try and asked them whether they con­sid­ered them­selves to be ag­gres­sive, bal­anced or con­ser­va­tive in their in­vest­ment ap­proach, Bradley says.

They were also asked what an­nual re­turn they would ex­pect to earn from an in­vest­ment strat­egy that matched their risk pro­file.

Club mem­bers who re­garded them­selves as ag­gres­sive in­vestors said they ex­pected an­nual re­turns of be­tween 4.5 per­cent and 25 per­cent, Bradley says. Those who re­garded them­selves as bal­anced in­vestors ex­pected re­turns of be­tween three per­cent and 25 per­cent, while those who re­garded them­selves as con­ser­va­tive in­vestors ex­pected re­turns of be­tween three per­cent and 20 per­cent, he says.

The club mem­bers’ re­sponses to the ques­tions were nei­ther log­i­cal nor re­al­is­tic, Bradley says. The lower-end re­turns are too low to earn a real (af­ter-in­fla­tion) re­turn, while the top-end re­turns are un­re­al­is­tic and un­sus­tain­able, he says.

In ad­di­tion, in­vestors tend to re­gard them­selves as more ag­gres­sive when mar­kets are per­form­ing well and their per­cep­tions of the mar­ket are pos­i­tive. When mar­kets are de­clin­ing, their per­cep­tions are neg­a­tive and they tend to be more con­ser­va­tive, Bradley says.

Iden­ti­fy­ing your­self as a par­tic­u­lar kind of in­vestor and iden­ti­fy­ing the re­turn you ex­pect does not give you any mean­ing­ful frame of ref­er­ence to make in­vest­ment de­ci­sions, Bradley says. In­stead, you must make de­ci­sions based on what you need to earn to achieve your goals, he says.

LIFE-STAG­ING IS EQUALLY RISKY

Life-stage in­vest­ing, in the same way as risk pro­fil­ing, is not an ap­pro­pri­ate way to de­ter­mine your in­vest­ment strat­egy, Bradley says.

Life- stage in­vest­ing matches your as­set al­lo­ca­tion to your age, putting you in a more ag­gres­sive in­vest­ment strat­egy when you are young and mov­ing you to a more con­ser­va­tive one when you are older. It is of­ten used to de­ter­mine an in­vest­ment strat­egy for re­tire­ment fund mem­bers, Bradley says.

But life-stage in­vest­ing as­sumes that at a par­tic­u­lar age ev­ery­one has the same ac­cu­mu­lated sav­ings and the same needs in re­tire­ment, whereas this is not the case, he says.

One fund mem­ber may have started sav­ing when he or she was 20, while an­other may have be­gun only at age 40. The mem­ber who starts later needs to have a more ag­gres­sive in­vest­ment strat­egy or must make other trade-offs, such as work­ing longer or plan­ning to live on less in re­tire­ment, Bradley says.

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