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An alternative approach to financial planning

28 September 2007 Gareth Stokes

On Tuesday, 18 September 2007 we attended a breakfast seminar hosted by the Association of Collective Investments (ACI). The seminar was billed as a Financial Planners Forum and did not disappoint. Risk profiling is entrenched in modern day financial p

The problem is that planners tend to focus too much on risk profiling rather than the complexities of human behaviour and the specifics of investment risk. Client behaviour is about more simply assessing a risk profile.

In today's feature article we examine some of Robert Macdonalds views on financial planning. Macdonald is Head of Xchange Solutions.

Understanding human behaviour

Macdonald uses a three forces diagram to illustrate the complex behavioural influences affecting individual investors. These forces included cognition, social pressure and emotion.

The term 'herd mentality' is often used to describe investor reaction to stock market price fluctuation. Social pressure means that people are prone to herding. The first sign of market concern often triggers a stampede of selling. "People tend to compare themselves to others and often behave in response to the behaviour of others," said Macdonald. This often results in them taking decisions based on what others are doing, rather than what is best for them.

This social interplay is aptly demonstrated by a recent television commercial. A schoolboy is asked to choose one of two coins, a R5 or a R2. He chooses the smaller denomination and becomes the laughing stock of his class. The 'bullies' repeat the trick time and time again to extract maximum value from the 'joke'. It is only when one of his friends asks why he always picks the R2 coin that the true victims emerge. "How many times do you think they would offer me the money if I took the R5?" he asks.

The lines between pleasure and pain

Lyrics from an old Was Not Was song read: "The line between pleasure and pain can't be measured by means of the brain" Macdonald uses an interesting pain versus joy graph to demonstrate the impact of emotion on human behaviour. The crux of the matter is that investors experience the pain associated with a loss more intensely than the joy associated with a gain of the same size. Emotion can wreak havoc on investing strategies. It causes investors to discard valuable market truths like "cut your losers; let your winners run."

Cognition deals with individual mindsets and how people perceive their environments. Given the same set of information, different individuals will draw different cognitive conclusions, which might not always be correct. Human behaviour is easily influenced as demonstrated in the following example. Researchers compared responses to two similar questions: "Do you get headaches frequently, and if so how often?" versus "Do you get headaches occasionally, and if so how often?" The results proved that how the question is framed influences how a test group responds.

Once financial planners understand the concept of complex human behaviour they can focus on getting to grips with investment risk.

Focus on investment risk

If you regularly attend financial presentation you will be familiar with the concept of risk and return. You will know and understand that investors have unique risk tolerances which can influence their investment decisions. Basic economic theory enshrines the concept that an investor will only accept additional risk for a concomitant increase in return.

You will also know that of the basic asset classes, cash or cash equivalents are less risky, while equities offer higher risk. Macdonald provided a fantastic graph illustrating the returns on these asset classes over 100 years. A R1 investment in cash would today be worth R264. The similar amount in bonds would have grown to R481. But in equities, the investor would be sitting on a massive 94, 419

What investors should take from this is that over longer periods they are more than adequately compensated for the additional risk associated with equities.

A new seven step approach to financial planning

MacDonald finished his presentation with a seven step approach to financial planning:

1) Set financial goals with the client

2) Quantify the required rate of return

3) This will determine the asset allocation

4) This will determine the investment risk

5) Test the client's ability to tolerate the investment risk

6) Adjust according to risk tolerance of investment

7) Review as personal goals or circumstances change

As you can see, this is a paradigm shift from performing risk profiling at an early stage. Instead of the investment decision being influenced by the risk profile, it is driven by the client's goals and the required rate of return. Risk tolerance is only introduced at the fifth step by which time the client is well acquainted with his financial goals and the rate of return he needs to achieve to meet them. It is essential to realise that asset allocation and not the investor determine the risk in the financial plan. Paying proper attention to the required rate of return to achieve stated financial goals and minimise the danger of pushing clients into conservative portfolios at too early a stage.

Editor's thoughts:
The 'lifestyle' approach to financial planning is similar to the seven step process suggested by Macdonald in today's article. In this process the financial planner delays excessive conservatism in the asset allocation process till well into retirement. What are your views on the seven step financial planning process discussed today? Send your comments to
gareth@fanews.co.za

 

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