We need to change the way we think about risk so that advisors and investors can speak the same language and lock in long term growth.
By Hester van der Merwe CFP®, Ultima Financial Planners, Financial Planner of the Year 2020
Risk profiling is a contentious subject in the investment universe. There was a time when every initial financial planning consultation began with the client filling out a risk profile questionnaire, which resulted in him or her being classified as “conservative”, “moderate” or “aggressive”. This classification then determined the underlying asset allocation of the investor’s portfolio – the relevant exposure to equities, cash, bonds, property etc.
But this approach was problematic, for three reasons. Firstly, it only took into account the investor’s emotional reaction to market volatility – and this was usually irrelevant. How a person feels when confronted with short-term market movement may have very little in common with what that same person needs from his or her portfolio. Secondly, the questionnaires themselves were inconsistent: There was (and still is) no industry standard to regulate these documents, which resulted in a wide range of outcomes. Finally, the same questionnaire often resulted in different outcomes for the same person under varying market conditions. In other words, people tend to be aggressive when markets are doing well, but they veer sharply towards conservative during or shortly after a market correction.
Because of these reasons, risk profiling can have devastating consequences. Take one of my clients, for example: She invested 20% of her salary over 30 years but found that she could not afford to retire since she’d used a 100% cash portfolio – a decision she’d based on her father saying that one should never take any risks with pension money! Indeed, it’s a planning disaster if a young investor still accumulating assets for retirement is classified as conservative, and presented with a portfolio underweighted in growth assets.
The opposite can be just as problematic… Picture the dilemma if an aggressive investor has been offered a high-risk portfolio and suddenly needs to withdraw the funds, only to find that the capital value has declined due to a market downturn.
Don’t throw the baby out with the bathwater
Does this mean that risk tolerance assessments should be swept under the carpet, never to be mentioned again? No! Humans are emotional creatures and even though the perception is that we make financial decisions based on facts and calculations, the truth is that our emotions play a significant role in the process.
During the term of an investment, an investor’s emotions might range from optimism and even euphoria to anxiety and desperation – simply depending on the state of the market. Totally disregarding the risk tolerance of an investor is therefore just as devastating as over emphasising it.
Using a well-constructed questionnaire can help both the financial planner and the investor gain new insights into behavioural patterns and beliefs about money. While this information should never be used as the sole basis for structuring an investment portfolio, it can add value if applied in the correct manner.
For example, research has shown that jumping in and out of the market at the wrong time can cause irreparable harm to a portfolio. Knowing the investor’s risk tolerance can help mitigate this behaviour, which will be of great benefit in the long term.
Try to avoid the “R” word
Language is powerful. KA Lindquist, Associate Professor of Psychology and Neuroscience at the University of North Carolina, said it best: “Language can be no more removed from emotion, than flour can be removed from an already baked cake.”
That’s why we need to take heed when addressing the issue of risk in the investment environment. The word has negative connotations and creates unease when used inconsiderately. What makes it even more dangerous is the fact that there are so many different interpretations. The following phrases can all refer to “risk” in an investment context: capital loss, short-term volatility, not reaching an investment objective… The list goes on. Should we not focus on describing the issue at hand rather, instead of describing everything as “risk”?
Take this catchy old cliché: “Your biggest risk is not including enough risk in your portfolio.” (Yes, I know the seasoned investors are grimacing!) It’s a simplistic statement, but it’s also a good summary of the dilemma we face when dealing with the concept of risk, and it speaks to the importance of embracing plain language when dealing with financial planning issues. Many investors are knowledgeable, and information is easy to obtain online, but your financial advisor still has an important role to play – deciphering the jargon and unpacking concepts in a way that makes sense. If yours isn’t speaking your language, it might be time to look for a new one…
With my clients, I always take a balanced approach when dealing with risk tolerance. I use questionnaire tools to deepen our relationship and to help my clients gain a better understanding of money behaviour, then I use that information to emphasise the importance of placing investment goals ahead of emotion.
Risk is not a bad thing or something to be afraid of, and it also means different things in different contexts. By interrogating your own relationship with the subject, you can prevent yourself from acting rashly and make the right decisions for long term, stable growth.