YOUR APPETITE FOR RISK
Some financial advisers use risk profile questionnaires to determine how well you can tolerate the risk you need to take to meet your needs. However, even when they are used in this way, risk profile questionnaires produce nothing meaningful about your appetite for risk, Andrew Bradley says.
The brain is a backward looking, pattern-seeking device that helps us to simplify our complex environments, he says.
As a result, we suffer from various biases, such as overemphasising the recent past, relying on stereotypes, overreacting to new information and using mental shortcuts – for example, assuming that more expensive items are of better quality. Risk profiling exploits these biases and will never be accurate, Bradley says.
Your psychological profile, perceptions and feelings change all the time, he says. Your perceptions will influence how you answer a questionnaire, as will your level of financial well-being and security, Bradley says.
For example, he says, some questionnaires ask you whether, on buying a new car, you would insure it fully with a small excess or a large excess, or not at all.
The person who answers that he or she would insure the car fully is then often regarded as a conservative investor, whereas the person who answers that they would not insure the car at all is said to be an aggressive investor.
But your level of insurance is likely to be determined by your perception of the risk of your car being stolen or involved in an accident, rather than your appetite for investment risk, Bradley says.
Your cash flow may also influence how much insurance you take out, he says.
Bradley is of the view that your financial adviser needs to explore with you your ability to take investment risk.
Your adviser needs to work out the possibilities and probabilities for the investment strategy you need and show you how often during the investment term you can expect your investment to have negative returns, he says.
Bradley says you can ask yourself questions, such as “How would I feel if I see that my R100 investment has became R80 as a result of market movements?”. Could you and would you have the confidence to stay invested and await a recovery?
If you then feel you cannot tolerate the real risks of the investment strategy you need to adopt to achieve the required return, you can explore alternatives. For example, if you are saving for retirement, you can consider working longer, scaling back on your retirement income or lowering your current standard of living to save more, he says.
Bradley is of the view that questionnaires are useful only in helping your financial adviser to understand your attitudes and biases, which, in turn, will help your adviser to know how to engage with you in way that is meaningful for you.