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
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.
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.