Risk profiling may pose a risk for clients – Absa

Risk profiling tools used by financial advisers to develop the investment strategies of thousands of clients might be more of a hindrance than a help in building long-term wealth.

The alert comes from Absa Multi Management, a firm that constantly monitors investment outcomes versus mandates and the balance between investment risk and return.

Johan Gouws, Head of Absa Multi Management, has put out the industry equivalent of a cautionary statement on the hidden risks of using risk profiling as a primary advice tool.

He believes risk profiling is a one-dimensional advisory approach and advisers and their clients should focus more on investment objectives and time as a defence against short-term risk.

Misunderstandings are also possible when terms like ‘risk’, ‘conservative’ and ‘aggressive’ are used.

“Risk means different things to different people,” says Gouws. “It is important to understand what the real risk is that the investor is concerned about before jumping to conclusions about their investment preferences.”

Profiles derived from a standard questionnaire usually fall into categories such as ‘Conservative’, ‘Conservative to Moderate’, ‘Moderate’, ‘Moderate to Aggressive’ or ‘Aggressive’.

Conservative investors typically have low equity exposure while equity weightings are stepped up for aggressive investors.

Gouws cautions: “Placing too much emphasis on the risk profile could have dire consequences for investors in their quest for financial independence in retirement.”

“Labelling an investor ‘conservative’ could result in an investment strategy that is too cautious given the investment objective and time horizon involved.”

Watching daily movements in portfolio values (as a result of heightened awareness of risk tolerance) could lead to short-term focus, reliance on market timing and an emotional approach that induces investors to jump between investments; selling after a market slide and buying after most upside has been realised.

What’s the alternative?

“Focusing on the client’s investment objective by taking into consideration their unique personal circumstances provides a sound starting point to appropriate advice,” says Gouws.

Having determined the objective, the optimum investment strategy can be developed. Understanding the relationship between risk, return and time is crucial. The power of compound growth should also be strongly emphasised.

“This will likely result in a more sustainable, objective-led investment advice approach that recognises inflation as the real risk to investors,” says Gouws.

“Setting clear investment objectives and time horizons based on life stage priorities, designing an appropriate investment strategy and allowing the benefit of time as an effective diversification mechanism offers a more objective and robust approach to the realisation of long-term wealth.”

He notes: “To achieve returns above inflation, you need to invest in more volatile asset classes which have historically proven their inflation-beating characteristics.

“Wealth creation is typically a long-term objective, implying a long investment time horizon. A long horizon, together with effective asset class diversification, reduces the risk of capital loss.

“In this scenario, risk profiling takes its rightful place as a secondary advice consideration.”

Applying a conservative low-risk strategy when there is plenty of time to build wealth runs the risk that investors will fall well short of their objective. They then have to save more or delay retirement.

Given pressure on household budgets and a tough business environment, this might not be possible.