Take a deep breath, ’cause this is a deep one.

i have set out below a bit of information on one of the core “tools” that is used in the financial planning industry in an attempt to apply some measure of science to the selection of approriate investment assets. It is actually only a superficial look but should be enough to give you an idea of how this system works, and some of the difficulties inherent in its application.

On looking at it, i have been a bit wordy… and i have no excuse other than a possible lack of sufficient coffee.

Risk Profiling as used in the financial planning industry is a tool that asks a series of questions of clients to which each answer is ascribed a score. The accumulated total score then provides a figure that is compared with a predefined listing of “Risk Profiles”.

 

Risk Profiles are traditionally “Conservative, Balanced, Moderate, Growth”. From these profiles, the financial planner will look at their research to identify investment portfolios that provide the mix of return and risk that best matches or is seen to be most appropriate to those groupings.

 

More specifically, the risk profiling tool is intended to interpret investment behavioural traits of the investor, with those traits being interpolated to form the basis of how a clients portfolio is to be allocated between various classes of assets (ie, shares, property, cash).

 

There is a number of risk profiling tools available within the industry, with each large Financial Services group requiring their financial representatives (ie, financial advisors) use this when deciding how to invest or allocate a clients’ money.

 

The most scientifically researched tool is that provided by FinaMetrica (accessed via http://www.riskprofiling.com). From memory, this was from a business originally started by Paul Resnik, who for many years has been a prolific and eloquent commentator on financial planning tools and developments. The FinaMetrica system is academically robust, combining an on-line risk management questionnaire with back-office feedback processes, which allow for ongoing incremental changes to the analysis process underlying that questionnaire. In other words, they continuously match the demographic of the subject with the associated outcome to measure any group bias that may exist. The FinaMetrica system is one of the better systems available in that it does not “feed” the subject into any particular profile or associated outcome.

 

WSP has extensively reviewed the available “Risk Profiling Tools” available within the market and this has been an ongoing process that has taken place over many years. The initial reviews in the early years of our establishment identified a number of areas of potential for misunderstanding and for misinterpretation by the advisor and the subject (investor). These difficulties often arise from a conflict of interest on the part of the groups providing the risk profiling “tool”. This is caused by a fundamental underlying bias for or against a particular form of investment or strategy. In addition, financial conflicts of interest often distort the process. Examples of this include:

 

1. Asking questions that relate predominantly to cash or listed securities,

2. A lack of questions addressing residential investment property,

3. A lack of questions addressing existing or past investments undertaken,

4. A lack of questions on issues surrounding but not directly related to investment (such as “How do you arrange your personal paperwork?” or “How do you complete a tax return?”)

 

An example of the kinds of conflicts that can exist from these defects is that the questions will predominantly (or solely) reflect issues surrounding the products and services offered by the group that provides the financial planner with their licence to operate.

 

WSP has found that very few questionnaires assess the subject’s previous actions in the light of professional advice. In other words, does the subject have a track record of acting outside of their stated “investment profile” when acting under the mantle of professionally provided advice? As an example, a person who considers himself or herself extremely conservative may quite comfortably borrow a large amount of money and purchase an investment property if their Accountant suggests that they do this. Many clients would not invest into managed funds at all if they were not able to access advice from financial advisors. Another example of this is the disproportionate percentage of superannuation funds throughout Australia that are held in “default” funds.

 

The questionnaire process does not cater for the varying “profiles” that a subject could have from this – and hold concurrently. Those investment profiles will also change over time.

 

The initial questionnaire difficulties are compounded by the subsequent interpolative recommendation process, which assumes that all clients can fit within four to six “investment profiles”. These profiles are allocated “model portfolios” carefully researched and developed using Modern Portfolio Theory to come up with a expected return and risk (measured as standard deviation of fixed time period return figures).

 

Difficulties in this process include:

 

1. Semiotics and language. What an advisor understands when they hear the word “risk” is different to what a non-advisor hears.

2. Myths and scope. The general community and mainstream media have pre-existing perceptions of financial planners/ managed funds/ superannuation/ risk that can differ widely from the industry perceptions of itself.

3. Modern Portfolio Theory provides expected returns and risk measures that are based on limited time scales. Therefore, the same time limitations flow through to any portfolio established within those scales.

 

In effect, there is often a fundamental miscommunication of risk and return inherent in discussion between advisors and clients and that miscommunication is exacerbated by the use of risk profiles and model portfolios.

 

These tools provide a “disconnect” between the advisors’ ability to provide facts or historical data with an ability to translate that in to an expected future outcome.

 

A more holistic approach is to engage clients in an ongoing process of considering their attitudes to risk. This involves their stated preferences independent of what could be a biased questionnaire. To enlarge on this broad statement, how many questionnaires ask questions specifically relating to residential property? The importance of this cannot be over-emphasised. If left to their own devices, the average Australian will accumulate sufficient cash to allow them to eventually purchase a residential property and if they have sufficient additional resources (and consider themselves able to bear the risk) will then speculate with individual share purchases.

 

The planner is predominantly seeking to help the client identify how much, if any, of their funds can be placed into long term investments. That is, investments with a time frame in excess of a full business cycle (which can be anything from 5 to 14+ years). Money required for shorter time frames than this should not be invested outside of cash unless there is a very strong accumulation of reasons to do so.

 

It could be argued that the deficiencies in the process would suggest a minimal exposure to “conservative” type investment pooled managed funds. This is a rather heretical statement but we are here to discuss and assess, so here is the idea behind that statement.

 

These funds invest into a number of areas that clients do not necessarily understand and the term “conservative” puts forwards an expectation that is not likely to be met by the investment characteristics of the pool itself. For example, the fixed income exposure for such funds is of a “bond” nature, in which the capital value moves inversely proportional to the interest rate. In 1994 many retirees were surprised to discover that their conservative “income” funds would not pay an income for over two years. This is the financial planning equivalent of the Westpoint and Brokers’ Scandal debacles, in which investments were presented as holding a risk/return profile that was not in line with the expectations of the investors. Again, this has more recently been borne out with the global debacle within the fixed income area in which CDO’s, Auction Rate Securities, Mortgage Securities and other financial instruments have done nothing more than present characteristics inherent in their structure – and yet this performance has been met with disbelief by investors, analysts and institutions.

 

I have attended informational updates in which retail investment products for investors seeking income have been released, which include these type of securities in the underlying portfolio. It could be (and is) argued that risks associated with these financial instruments are moderated through diversification and the research capabilities of the investment manager. This may be true but the allocation of a client’s money into that portfolio on the basis of a (for example) 20 point risk profile questionnaire creates room for misunderstanding.

 

A reasonable approach is to seek to clarify the expectations of clients in the broadest financial sense. There is then discussion on the various methodologies for achieving those expectations and whether the advisor is able to provide assistance in the areas that clients are comfortable to proceed with.

 

These comments do not mean that I am relegating to a rubbish bin the massive research effort underlying portfolio construction, and investor behaviour research upon which the financial planning industry is based. Rather, it is an acknowledgement of the fundamental bias and prejudice that impinge on any valid assessment of individual investment understanding and behaviour.

 

The best outcome is when a planner or advisor attempts to use open and honest discussion and disclosure as a tool to help a client assess their ability to deal with the risks associated with an investment that is recommended for them to achieve their goals.

 

This is in contrast to the industry standard approach of using a risk profile to determine what a person should invest in, which will then determine their likely outcome.