PLANNING POINTS

RISK profiling is a contentious subject in the investment industry. 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 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. First, it took into account only the investor’s emotional reaction to market volatility – and this was usually irrelevant. How a person feels when confronted with short-term market movements may have little in common with what that same person needs from his or her portfolio. Second, the questionnaires 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 different 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.

For 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 because she’d used a 100% cash portfolio – a decision she’d based on her father saying that

HESTER VAN DER MERWE 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 underweight 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 because of a market downturn. 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 overemphasising 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. Although 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 to mitigate this behaviour, which will be of great benefit in the long term.