Risk profiling - important and useful
Nastasja Hart, Wealth Manager at GCI Wealth.
Risk profiling is a topic that raises many hackles in the financial planning industry but, used properly, it can be an effective client-engagement tool and can materially advance Treat Customers Fairly objectives.
Risk profiling is something of a hot topic in the financial planning industry at present. The Financial and Intermediary Services (FAIS) Ombud and the Financial Services Board have clearly indicated that they see risk profiling as an important and integral part of the advisory process, and a pillar of the Treat Customers Fairly (TCF) initiative. By contrast, many financial planners see it as a highly problematic exercise, and one that they only undertake in the interests of compliance.
While the industry’s reservations are grounded in hard experience, the fact is that risk profiling is here to stay. If we as the industry do not resolve the issues, then we will find the regulator taking action. This is good reason for solving the challenges relating to risk profiling, but even more compelling is the fact that, properly handled, risk profiling is an excellent tool capable of helping financial planners service their clients much better.
At the outset, we need to understand why so many of us had such negative experiences relating to risk profiling. There appears to be two main reasons: the questionnaires/ models were flawed, and there was a fundamental disconnect between planners and asset managers.
In respect of the first point, the Ombud has pointed out that many questionnaires were not sufficiently well constructed or phrased, and thus failed to provide a genuine guide to the most appropriate investment portfolio for an individual client.
It’s worth noting that these issues are not unique to South Africa, and pertain to many other markets. One benefit is that much work has been done on the question of risk questionnaires and modelling, and so financial planners now have access to much better questionnaires. The problem is not completely solved, but the position is better.
On the second reason, it is clear that the definition of risk, the design of risk profile questionnaires and then the design of the investment portfolio itself were left too much to the product suppliers/ asset managers. This lack of a single vocabulary often meant that clients, planners and providers were speaking past each other—but the poor planner was the one held accountable for everything.
Again, there has been a clear improvement in the status quo, driven by the impact of TCF. TCF has brought financial planners and product providers/ asset managers much closer. As a result, providers are beginning to rephrase their jargon in ways that make it more understandable to the end client.
Thus, for example, “standard deviation” is now being replaced by the plain English “possible temporary or permanent capital loss”. Even closer collaboration will enable the two parties to define risk from the client’s point of view, and develop industry standard terms for categorising funds’ risk profiles, making it easier for planners and their clients to match the individual’s risk profile with that of the funds chosen.
In other words, a “conservative” fund would be expected to deliver returns within a certain range with a stipulated risk of capital loss, and so on.
How risk profiling can help
Very briefly, these are ways in which risk profiling can be made much more useful and accurate, and so prevent financial planners from finding themselves on the wrong side of the regulator. But, as always with governance and compliance issues, adopting a tick-box approach is short-sighted. In my experience, risk profiling should be seen not as something that has to be done in order to protect oneself, but as something that can help you do a much better job of serving your clients.
In particular, undertaking the risk-profiling process as part of the client take-on process is extremely valuable. In particular, it’s an opportunity for both parties to understand the various facets of risk: the client’s appetite for risk, the risk that will have to be assumed in order to achieve the client’s goals and, critically, the client’s capacity for sustaining worse than anticipated investment results.
Considering risk multi-dimensionally like this is never going to be easy, because it forces both the client and advisor to confront the real issues, but no better way of understanding your client’s needs exists—nor of educating him or her about the realities of investing. The end result will be a more fruitful relationship for both parties, with less risk of tears.
