Anton Swanepoel, industry expert and author, outlines how risk profiling has evolved over time. Clients’ needs and objectives are central to the advice-led approach to investing.
The traditional approach
Traditionally, clients filled out a questionnaire and after being classified as either a conservative, moderate or aggressive investor, were then presented with a corresponding conservative, moderate or aggressive investment solution. Two main flaws with this approach are that some of the questions are not relevant to specific investors, and also that the terms conservative, moderate and aggressive are relative and open to interpretation.
This approach has led to the provision of investment-led proposals based on how the client feels about risk, without a deeper understanding of the client’s personal situation. This results in a product solution rather than an advice-led solution.
Advice-led approach to investing
Risk tolerance questionnaires are helpful, but they are not the only component of a risk profile. A client’s needs and objectives must be established – but very often these oppose their risk profile. The risk profile should never overpower the needs and objectives.
Doing a complete analysis of the client’s situation will give an indication of a realistic rate of return that can be achieved over the term of the investment, e.g. the need could be to retire in 20 years, or for a medium-term goal in five years’ time. The rate of return over the period will suggest an appropriate solution. Only then is it possible to make recommendations.
If the client’s risk profile doesn’t accommodate the solution needed to meet the required rate of return, they will need to decide which is most important: their objective/need, their risk profile, or if there’s a middle ground between the two.
Required rate of return, required risk, risk tolerance and risk capacity all need to be determined as part of the advice-led process before an optimal recommendation can be made.
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The Financial Planning Institute of Southern Africa (FPI) and the Financial Intermediaries Association of Southern Africa (FIA) have put together a risk-profiling framework to serve as a point of reference.
Read: Professional investment advice: Risk-profiling as a component of suitability
