I have been speaking to a lot of new clients recently who are not happy with their current investments. In all cases, they either spoke to their bank or went directly to the insurance company, and they felt that the advisor who spoke to them didn’t get much understanding of what they are about. They just got them to complete a risk profiling test which came up with suitable fund at the end. Never mind that the funds they recommend tend to be very expensive, under performing funds, this method of making investment recommendations was found to result in poor advice in 2011 by the UK Regulator. Completing a risk tolerance questionnaire should only be one part of forming someone’s risk profile so an advisor can fully understand a client
Is there a goal to be achieved? If we know how much money you have now and how much you need in the future, we can work out the return you need to achieve from your investment. A typical example here is people planning for their children’s future education.
But if you don’t have a specific purpose for your investment, don’t worry, you’re in good company. Most people just have surplus money that they want to grow so they can use it in the future. Financial Planning may help you in this case to help you identify some goals that you want to achieve in the future.
This is very important in people’s minds. A pension is a long term investment and so people are more accepting of the ups and downs of the markets; afterall, you can’t access the money for decades so it makes no difference to me today if the market falls.
Likewise, if it is an investment for a shorter period of time, you feel the effects of volatility more. If you need the money in 5 years time, you have a shorter time frame for the money to recover if there is a crash during the investment term…or you have to stay invested for longer than you wanted to.
This ties back to the purpose of the investment. If we know the goal, we can work out the return required. But don’t worry if you don’t know the exact value. Afterall, it is almost impossible to know exactly how much you need when you retire when it is decades away. Lots of things will happen in life between now and then to change this need. In these cases, a percentage of salary is a good benchmark.
How risky does the investment feel to you? During the Celtic Tiger and now again, property didn’t feel like a risky investment to anyone in Ireland. But in 2009/10, even people with money wouldn’t buy property as their perception of property changed.
It is the same with equities. When the markets are producing strong returns, people’s confidence in the market grows and they invest, usually at the top of the market. It is important that people know the type of risk they are exposed to when they invest. What kind of falls have happened in the past, how long did they last for and how long did it take to make your money back.
When making any investment outside cash deposits, there is an element of investment risk so it is very important that you understand how much you are taking.
Risk tolerance is psychological. It expresses how you feel emotionally about taking risk. In other words, how far does your investment need to fall in value before you start screaming at your advisor.
Risk tolerance is the risk profiling questionnaire that you would have completed. It should only be a part of the whole investment process. A starting point to kick things off in understanding someone’s attitude to investing.
The most important factor of all. How far can your investment fall in value before it has an impact on your lifestyle. Do you have other assets you can use for income while your investment recovers in value? Do you need the money you are investing at all to fund your lifestyle?
This is where some of the insurance company’s profiling fail miserably. They do not ask whether a client can afford a large fall in value. I score high in risk profiling questionnaires. I am 42 years of age so if my pension falls in value (as it is now!), it has zero impact on my lifestyle. But what about a 65 year old retiree who is drawing down her pension? If she scored the same score on a risk tolerance questionnaire, would you put her in the same investment funds as me? A fall of 40% in value could have a serious impact on her retirement? She may have to cancel plans she had until the markets recover.
Are there differences between the required return and the levels of risk associated with that and your risk capacity and risk tolerance? If so, what trade-offs are required? These are usually resolved by one (or more) of the following:
You can see that there is a lot more to evaluating a suitable investment portfolio for someone that just getting them to complete a risk profiling questionnaire. This is just a box ticking exercise for the regulator, it is not providing you with good advice. Investing money can be a scary thing for a lot of people who have not experienced the ups and downs of the markets. You need to be assured that the investment strategy you have chosen is one that won’t keep you up at night.
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