Moonstone: Defining risk profiling more accurately

We received a very interesting article entitled “The Use of Risk Profiling Questionnaires in South Africa” written by Cobus du Plessis of the Institute of Behavioral Finance.

He makes the point that what most people regard as acceptable in determining the risk profile of a client in terms of legislative requirements may not necessarily be the sufficient in terms of what the client requires.

“In most instances the completion of the risk questionnaire is linked to the selection of one of five investment portfolios ranging from conservative to aggressive, according to which the client’s entire investment is invested.”

A closer definition of what is actually meant by different descriptions may be required:

“Different terms such as risk tolerance, risk attitude, risk capacity and risk appetite are used to describe risk related concepts, not necessarily with the same meaning.”

The article expands on the term “risk tolerance” which it defines as “… the extent to which a person chooses to risk experiencing a less favourable outcome in the pursuit of a more favourable outcome.”

In discussing client reaction to unsatisfactory investment returns, a distinction is drawn between those clients who are only concerned about unsatisfactory returns and not the advice, and those who are unhappy with both. He blames the latter on the fact that the client did not commit fully to the advice as all relevant risks were not properly assessed.

Those who were satisfied with the advice made an “informed commitment” to advice that included “…proper consideration of risk tolerance, which is but one of three risk related inputs into portfolio recommendation. The other two being the risk taken to achieve one’s goals (risk required) and the risk one can accept without changing one’s goals (risk capacity).”

In essence, what is legally required of us is to provide advice that will allow the client to make an informed decision. This article takes it a step further by making a case for the client making an informed commitment, which is far more preferable in terms of retention of business.

The above is at best a brief summary of an article which all serious advisors should read carefully as it contains a wealth of valuable information. Please click here to download a copy.

My sincere thanks to the Institute of Behavioral Finance for their continued assistance in helping to make our environment that much more understandable.