Historically risk profiles were used to lead customers to buy specific products. Few of these plans had the actual welfare of the client at heart.
Some of the more modern versions are often used as an alibi to protect advisors against complaints to the Ombud or claims for losses incurred by unhappy clients, rather than the establishment of the client’s true risk profile.
A recent discussion on this topic drew quite a bit of attention in the financial media.
Laura du Preez writes in Personal Finance:
“… in a debate at the annual conference of the Financial Planning Institute (FPI) this week, the two experts – Andrew Bradley, the chief executive officer of Old Mutual Wealth, and Anton Swanepoel, the vice-chairperson of the financial planning executive committee of the Financial Intermediaries Association of Southern Africa (FIA) …were divided on whether or not advisers have to use the questionnaires to comply with the regulations that govern how advice must be rendered.”
Bradley says risk-profiling questionnaires are fundamentally flawed and cannot be fixed. The answers to such a questionnaire will not secure your financial future, he says. Instead, they could result in your not achieving your financial goals. This does not mean that risk is not important and should not be assessed and managed.
Swanepoel says he believes that 90 to 95 percent of questionnaires are flawed and instrumental in the provision of bad advice. He says your risk tolerance – or how you feel about risk – should not drive your decisions on how much risk you take, and should be only one component of the analysis of risk.”
Pieter Koekemoer, the head of retail at Coronation Fund Managers, alluded to the need to bear the principles of Treating Customers Fairly in mind in product design.
An International Perspective
FinaMetrica, an international provider of risk profile solutions, adds a third dimension to the mix:
Risk profiling is a process for finding the optimal level of investment risk for your client considering the risk required, risk capacity and risk tolerance, where,
- risk required is the risk associated with the return required to achieve the client’s goals from the financial resources available,
- risk capacity is the level of financial risk the client can afford to take, and
- risk tolerance is the level of risk the client is comfortable with.
Risk required and risk capacity are financial characteristics calculated using your financial planning software. Risk tolerance is a psychological characteristic which is best determined by way of a psychometric test.
Risk profiling requires each of these characteristics to be separately assessed so that they can be compared to one another. Risk capacity and risk tolerance both act separately as constraints on what your client might otherwise do to achieve their goals (risk required). It is unusual for a client to be able to achieve their goals from the resources available within both their risk capacity and risk tolerance.
Where there is a mismatch between risk required, risk capacity and risk tolerance, the advisor’s role is to guide the client through the trade-off decisions that are required to reach an optimal solution.
The final step in the risk profiling process is to ensure that the client has realistic risk and return expectations so that the advisor can get the client’s properly informed consent to implement the investment strategy.
A comprehensive discussion of risk profiling by FinaMetrica, and specifically applicable to South Africa, can be found in Risk Profiling: Art and Science. They work in close association with South Africa’s Institute of Behavioral Finance (IBF), the official representative of FinaMetrica in South Africa, to ensure a custom-made model for local needs.
FinaMetrica offers a free 30 day trial for those interested in testing their model.
In addition, Moonstone Compliance clients qualify for a 20% discount off their standard subscription price. Please select Moonstone under “Alliance” when subscribing.
For more information or assistance please contact Gerda van der Linde of the IBF on 082 881 6159.
