Determining your investment risk profile involves more than a questionnaire
● A financial adviser may ask you to complete a questionnaire while determining your investment risk profile, but the outcome of that questionnaire should not be the main factor that is driving your investment decisions.
At times you may need to take a higher level of risk than your responses to a risk profile questionnaire indicate you are willing to take. A good financial adviser will have a difficult conversation with you about moving beyond your comfort zone.
The case of an investor with a leading financial planner, whose tolerance for investment risk took a dive with the returns earned from local financial markets in recent years, illustrates this well.
The investor, who is two years away from retirement, had a plan in place with his adviser to ensure that by the time he retired, he would have sufficient savings to provide the income he required, of R40,000 a month.
To achieve this, his adviser, Janet Hugo, an independent planner from Sterling Wealth and the 2018 winner of the Financial Planner of the Year, determined that he needed his investments to generate an average return of 5% to 6% above inflation measured over seven-year periods.
Hugo worked out that the investor needed to invest across the asset classes but with a reasonably high equity exposure of between 40% and 60%, giving him the returns he needed and enough diversification to prevent him from experiencing the worst downturns in equities.
Hugo says while she isn’t a firm believer in risk profile questionnaires, she asks investors to complete them to determine how comfortable they will be with her proposed investment strategy.
But she knows the answers are subjective — and change as market conditions change.
When this investor originally took the risk profile test using the questionnaire drawn up by Finametrica, the test scores showed he was comfortable as a moderately assertive investor. Hugo invested him a little more conservatively than he indicated he was comfortable with, because at the time he invested, she was concerned about the state of the markets.
Now, after five years in which the JSE AllShare Index has delivered returns below its long-term average of inflation plus 7%, instead delivering on average inflation plus just 1.89% for the five years to the end of April, the investor repeated the risk profile questionnaire and his score reflects that he is comfortable investing more conservatively in a strategy designed to deliver inflation plus 3% over three to five years.
Hugo, however, says she had the difficult conversation with him, explaining that if he does this, his investment capital will be depleted by age 91. His family history indicates he may well live beyond this age.
He also has a younger spouse who is likely to outlive him and needs to be supported by his investments.
She made it clear that he needs to take investment risk that is greater than what he says is his tolerance level and that at times he will feel uncomfortable when his investment shows a paper loss over shorter terms.
He must understand that this is necessary in order to achieve the longer-term returns he needs.
In the most recent FAISTime newsletter, Marc Alves, team resolution manager in the Office of the Ombud for Financial Services Providers, says determining your risk profile involves much more than just completing a set of questions which generate a score that rates you as a conservative, moderate or aggressive investor.
Alves says risk profiling involves you deciding on the risk you need to take, the risk you can afford to take — your capacity for risk — and your tolerance for that risk.
The risk you need to take is determined from your investment objective or goal, your investment time horizon, your financial resources and whether you need to draw an income from your investment.
Your capacity to take risk is directly linked to the financial loss you are capable of absorbing, Alves says. If you are drawing an income or you have very limited investments and are no longer economically active, your capacity to take risk will be lower.
Alves says what the financial services industry often refers to as your risk profile as determined by a questionnaire is typically only your risk tolerance — or the level of risk that you are comfortable taking.
If your investment needs indicate you need to take more risk than you can typically tolerate, you should remember that risk and return is a trade-off — the higher the risk, the greater the return you should earn.
Usually you need longer investment periods as you take on more investment risk. Certain times — such as the period we experienced recently on the JSE — may test the return expectations you have, but you should only change your risk profile if your circumstances change — not because markets have been poor.
Hugo says she told the investor that he cannot afford to be invested in a conservative investment strategy, as he will then take on the risk that he might outlive his capital — a far scarier possibility than a few years of poor returns such as those many investors have recently experienced.