Perils of Risk Profilers
Published May 2016
Written by Shawn Yap CFP
For decades, the risk profiler has been used by financial advisers to determine clients’ risk appetites. However, the question remains if the risk profiler is a reliable tool for investment planning. In theory, the risk profiler is supposed to determine the risk tolerance of any client. In practice, humans are emotional beings and risk profiles change over time depending on both their life and investment experiences.
There is no standardisation of risk profilers among different companies.The number of risk profiles can range from three to six categories. Some of them tend to skew towards the middle category. Frequently, younger investors will almost always fall under “aggressive” because of their age and supposedly long investment time horizon, even with the absence of investment experience.
Although the client may choose conflicting answers where responses should be mutually exclusive in a risk profile, the outcome of the profile will still be accepted as long as there is an outcome at the end. Is this still compliant? Does the risk profiler stereotype investors with labels like “Conservative” or “Aggressive”? Let’s take a closer look.
Although this may be one of the most important questions in the risk profiler, some profilers have less than five years to as short as one to two years as their minimum investment time horizon. Strictly speaking, money with less than three years’ time horizon is usually not worthwhile to be invested especially when sales charges are taken into consideration. If the client selects too short a time horizon, the client should not invest at all as the risk profiler should be treated as invalid and documented accordingly. This would prompt a different kind of conversation between the adviser and the client. How about investors with a longer time horizon? Does it really mean that a young investor can ride through the major volatility of the economy? If the young investor cannot handle the emotional effect of negative returns in an economic recession, the client may avoid higher risk instruments altogether in future. The role of a financial adviser is to reduce the volatility, not ride through the volatility. A lump sum investment does not benefit from high volatility while a regular investment plan employing dollar cost averaging would take advantage of volatility. Therefore, different types of monies should adopt a different asset allocation.
Experience & Knowledge
Does it mean that an investor with more experience and knowledge can take more risk? Where knowledge is concerned, investors nowadays can easily increase their knowledge by attending free seminars, surfing online and following investment blogs. But does buying a few lots of company stocks and investing in a couple of unit trusts equate to having more experiences in investing? If they were really experienced, they would be investing themselves rather than seeking advice, except for the leverage of time. It is well-known that most investors are over-confident in a rising market (euphoric) and overly-fearful in a falling market (despair). Instead, an experienced investor should be someone who has gone through at least one full market cycle with gains and losses in the process that will provide a psychological preparedness for market volatility.
Who would not want the highest possible return with the least possible risk, zero if possible? Some risk profilers ask about clients’ expected returns in one question and potential loss in another creating an unlikely condition. Also, high risk does not literally mean high return. Most risk profilers use volatility parameters and not real- world statistics for their choices. Most financial advisers recommend unit trusts where a well balanced portfolio rarely exceeds 10% annual returns over one market cycle but yet illustrations can reach 20% per annum. At least that is what the clients will think. Take 20% risk, get 20% return! Even if real-world statistics are used, it must also state whether the outcomes are due to static or dynamic management like rebalancing strategies.
Short Term Loss Hypothesis
Short term is very subjective. It can be a couple of weeks, months or even years. This can be misleading especially based on a one- year basis. It assumes that the short term loss only occurs in one year and will recover in the next year. In reality, negative values can be seen for several years in an economic crisis. The emotional impact of a 10% loss can be very different between a $10,000 and a $100,000 investment. How about a million dollar portfolio? Losing 10% in a year can be too much to bear and seeing negative values for a couple of years will make it worse. In addition, an aggressive investor can change quickly to a conservative investor especially in a volatile environment.
Action If Investment Value Drops
Although we understand the psychometric part of this question, the conservative client would comment that the portfolio should not fall below a certain percentage in the first place. If the value really drops, are investors supposed to take advantage of the volatility to buy more at bargain prices? Should conservative investors forgo real opportunities like this? For the aggressive investor, let’s start with an initial asset allocation of 80% equities and 20% bonds and a sudden recession causes the equities portion to drop by 50%. What is the chance that this aggressive investor would still buy more after a 40% drop in investment value with a low allocation of bonds left and limited resources?
Investors Are Not Pigeons
Conventional risk profilers tend to pigeonhole investors into a fixed investment mandate with no considerations to current market conditions. Does it mean that a conservative investor can only invest in low risk instruments even if the stock market is at a bargain? Does it mean that an aggressive investor should still invest in a higher risk portfolio even if the stock market is over-valued? In a bull market (rising off the trough), opportunities may not be capitalised by conservative investors. In a falling market (from the peak), aggressive investors are exposed to the full down trend. Although timing is not important in investment, the timing of entry into equities is vital so is the exit and re-entry. Life cycle investing also suffers from this weakness. It just attempts to reduce equity allocation consistently over time. Therefore, it could take profit at the wrong stage of the market cycle.
Conventional risk profilers always focus on the personal profile of the client. Should we invest only based on our personality or should we invest to capture the best opportunities and reduce risks?
There is a time to be conservative and a time to be aggressive. As Bruce Lee said, “Be like water making its way through cracks. Do not be assertive, but adjust to the object, and you shall find a way around or through it. If nothing within you stays rigid, outward things will disclose themselves.” Obviously, a successful investment strategy should not follow an investor’s own personality. Instead, a good investment risk profiler should consist of two segments. The first segment is the Personal Profile while the second is the Climate Profile. An appropriate weightage between the two segments should be used.
The Personal Profile should have a built-in educational value and not just a tool. This will make sure that investors understand that they can never get a high return in a short time with a high degree of certainty. Short time horizon is never correlated to high probability of expected return. Investment is a probability game. Even if we invest in an undervalued stock or index, there is no guarantee of a positive return within a specified period. The closest measure is a probability. The probability of expected return increases with time. For example, based on a five-year time horizon, the probability of achieving a 1-3% annual return is medium to high while the probability of achieving a 3-6% annual return is low to medium. By placing all three parameters (expected return, time horizon and probability) together, clients will get a better perspective of their investment journey.
Next is the Climate Profile. Financial advisers and institutes should take more leadership in guiding clients through the different phases of the economy, not just fulfilling regulatory compliance in a way to avoid responsibility as long as the client signs off the risk profiler. The Climate Profile can provide basic economic data (interest rates, PMIs), cycle stage (early bull, late bear), market valuations (PB and PE ratios) and even technical trends. All the information would convert into points to give the risk profiler a bias towards the lower or higher risk. It is often counter-intuitive to do the right thing at the right time. “Being fearful when others are greedy and being greedy when others are fearful” is not as easy as it sounds. By incorporating the Climate Profile, advisers would prevent the aggressive investor from being the “greater fool” at the market peak and assist the conservative investor to “buy when there is blood on the streets”.
More often than not, advisers may be too dependent on the risk profiler to match client’s risk profile to the marketed investment product, rather than using it as a tool for holistic consideration. It is important to note that any client must have investments in all three time horizons: Short Term, Medium Term and Long Term for various purposes. Even if an aggressive investor has a long time horizon, especially a young graduate, that doesn’t mean the entire sum should go into a high risk portfolio. On the other hand, a retiree will always have a short time horizon or none at all and we should encourage this conservative investor to take advantage of any market opportunities as they come along. Never rely solely on the risk profiler for investment recommendation because the life stage of the client matters too, so does the latest investment climate.
This article first appeared in the May 2016 issue of Financial Planning magazine published by the Financial Planning Association of Singapore (FPAS).