There has been much debate about risk profiling and its relevance – or lack thereof – in determining an appropriate investment solution for customers. Stepping away from this controversy, we look at what else financial advisors should consider about the customer when deciding on an investment strategy.
Gathering information is a critical step in the financial planning process and a requirement in terms of the General Code of Conduct. But output is only as good as the data input, so it is paramount to ask the right questions that will help you to develop a holistic view of the customer. The way in which a question is asked will depend on the customer’s level of education and experience with investments. It will also determine the quality of the answer.
Your questions should help you understand three broad aspects of the prospective investor:
i. how much risk the customer is willing to take (risk tolerance),
ii. how much risk the customer is able to take (risk-taking capacity), and
iii. what risk the customer should take to achieve the defined investment objectives (risk requirement).
These aspects can often be in conflict and should be plotted against one another to find a best-fit solution for the customer.
Risk tolerance is the degree of uncertainty an investor is willing to take or can handle when there is a negative change in an investment portfolio value. Risk tolerance lies in the mind of an investor and indicates how much risk he/she wants to take. In other words, how will the investor react should there be a loss and if that loss increases?
Personality plays a role in the willingness to take risk and most people carry their personality into their investments. Someone who is conservative by nature in most aspects of their life may prefer low-risk investments, and vice versa.
Many tools are available to help gauge an investor’s risk tolerance, such as risk analysers. However, the focus should be less on the scorecard and more on the information gleaned from the customer when seeking information. Take time to understand whether the customer likes to take risks or prefers to play it safe. Your focus should be on understanding how the customer thinks.
Risk-taking capacity, or the customer’s ability to take on risk, depends on factors such as investment objective, investment time frame, age, income, number of dependents and accumulated wealth. These must be considered when seeking a solution that will best fit the customer’s circumstances.
It is also important to establish the customer’s primary objective for investing, as objectives determine expectations. Broadly, the objective may be to create wealth to meet financial goals, protect savings from the eroding effects of inflation or generate income. The advisor is responsible for drawing out the necessary information about the customer’s circumstances and asking questions about aspirations and expectations, what the customer wants to achieve and the anticipated outcome of the investment.
To ensure a multi-dimensional understanding of the customer’s circumstances, it is important to ask additional questions. For instance, find out if the customer would need access to his/her investment funds in an emergency, and if his/her medical aid and gap cover would cover risk and medical expenses in the event of an accident or contracting a disease.
Customers who require income from their investment should be asked whether they currently earn income. If they do, for how long will they continue to earn income and what increases do they expect? Do they anticipate their earnings will keep pace with inflation? Do they have a buffer in their budget to absorb any drop in real earnings? Do they need the income generated from their investment to grow in line with inflation? Do they anticipate any of their expenses to increase or decrease as they grow older?
By understanding a customer’s willingness and ability to take on risk in an investment strategy, you have a foundation on which to inform the customer of the risk he/she should take to achieve the defined investment objective.
We’ve spoken about two of the risk-related issues, being the willingness and the ability of a customer to take risk. The third one we mentioned above is what risk the customer should take (ie. the risk requirement). Sometimes we see customers who have a low tolerance for risk (eg. they are conservative and want guarantees), but they have a long timeframe to invest (in other words they have the ability to take risk), but their conservative personality holds them back from appropriate risk-taking – eg. a 26-year old who wants to invest for retirement. Similarly, an older customer who may be willing to take on risk, but shouldn’t because of the dangers of losing capital in the shorter term. It’s in cases like these where advisors have an important role to play in explaining the dangers of taking on too little risk in the one example and too much risk in the other.
There are other benefits of going beyond the one-size-fits-all tick-box approach. By educating customers through the financial planning process and building their knowledge, skills and attitudes so they become financially literate, they can shift from reactive to proactive decision-making. You are also fully discharging your professional duty of care as an advisor – and treating your customer fairly.