Many financial advisers still rely on risk profile questionnaires to assess whether your risk profile is aggressive, moderate or conservative or some variation of these three. Based on the outcome of this assessment, advisers decide on the asset classes in which you should invest.

But two financial planning experts have severely criticised the use of risk-profiling questionnaires. They argue that your investment needs, not your risk profile, should determine your investment strategy.

Andrew Bradley, the chief executive of financial planning company acsis, says in an article in InvestSA magazine that risk profiling is based on “dubious criteria and has resulted in some disastrous financial consequences for those who have invested their money based purely on their apparent risk appetites”.

Bradley is of the view that questionnaires have no role in determining either your investment strategy or your ability to “sleep well” with a particular investment strategy.

He says that acsis advocates profiling questionnaires only as a way for your financial adviser to get to know you and to determine how best he or she should engage with you and present you with a financial plan. For example, if your adviser determines that you are someone who understands and appreciates figures, these can be presented to you in the appropriate level of detail.

In an article entitled “The myths of risk tolerance”, Cobus du Plessis, a director of the Institute of Behavioural Finance, argues that questionnaires have no role in determining your investment strategy.

However, he says that well-constructed questionnaires should be used to determine your risk tolerance. The problem is that questionnaires are often constructed arbitrarily without any scientific discipline, Du Plessis says.

You can read the article on the institute’s website at www.ibfsa.co.za

The Institute of Behavioural Finance has been appointed to market in South Africa a psychometrically tested risk-profiling system that was developed in Australia to help financial advisers determine their clients’ risk tolerance.

Du Plessis says most South African advisers mistakenly believe that the questionnaires they use assess your risk tolerance, whereas the questionnaires serve as “asset allocation calculators” that supposedly determine an appropriate asset allocation for you.

Some of the questionnaires are developed by pro-duct providers, and your risk profile will be matched to a portfolio. For example, a conservative risk profile is matched to a conservative portfolio with a low exposure to risky asset classes such as equities.

Bradley says one of the greatest indictments against risk profiling is that the returns produced by risk-profiled portfolios have no relevance to the returns you require to meet your investment objectives. Your long-term lifestyle goals, and not your appetite for risk, must drive your investment decisions, Bradley says. If this is not the case, he says, you will eventually have a rude awakening and be forced to make significant changes to your lifestyle.

Du Plessis says a common myth is that your asset allocation depends on your tolerance for risk and this will ultimately determine whether you succeed or fail in meeting your investment objectives.

He says there are three aspects to risk:

* The risk required, which is the level of risk that you will have to take to earn the return that you require to achieve your goals. Du Plessis says this is a financial characteristic.

* The risk capacity, which is the extent to which the future can be less favourable than was predicted without your financial plan being derailed. This is also a financial characteristic.

* Your risk tolerance, which is the level of risk you would prefer to take. Du Plessis says this is a personality characteristic.

The asset allocation of your investments should be based on the risk required, the risk capacity and your risk tolerance, he says. Your financial adviser should guide you to accept the right balance between these risks so that your assets can be allocated correctly, Du Plessis says.

First, your financial adviser must determine the return that your investment has to earn in order to meet your goal. This return can then be used to determine the right allocations between asset classes.

The asset allocation strategy and the risk associated with it must be explained to you. If the risk exceeds a level that you would normally be willing to accept, you should be aware of the mismatch, and you and your adviser should then explore the trade-offs between this asset allocation and alternative strategies, Du Plessis says.

In finding the balance between the allocation you require to meet your needs and the one that won’t keep you from sleeping at night, he says, you and your financial adviser may have to:

* Find ways in which you can increase your resources by earning more, spending less or converting personal-use assets into investment assets;

* Scale back your investment goal by delaying, reducing and/or discarding it; and

* Accept more risk than you are comfortable with, but not to the extent that this may induce you to panic and sell your investments during a market downturn.

Du Plessis and Bradley agree that your financial adviser must understand your tolerance for risk, but they disagree on how your adviser should determine your ability to sleep well when taking investment risk.

Bradley says although it is critical that your adviser understands your risk tolerance, this cannot be determined by using a risk profile questionnaire.

Du Plessis says your adviser is professionally, legally and ethically obliged to take your risk tolerance into account when advising you. To form a view on your risk tolerance, your adviser needs to use an objective assessment in the form of a scientifically designed risk questionnaire, he says.

Bradley says there is no accurate risk profile. An individual's psychological profile, perceptions and feelings change all the time, he says.

Your perceptions will influence how you answer a questionnaire, he says, as will your level of financial well-being and security.

For example, he says, some questionnaires ask you about your level of insurance cover and use your answer to determine your appetite for risk. But often your level of insurance is determined by cash flow or your perception of the risk of, for example, your car being stolen or involved in an accident, rather than your appetite for risk, Bradley says.

Your adviser has to consider your risk tolerance by engaging with you about the investment strategy you need to follow to achieve your goals, he says.

The discussion about your risk tolerance becomes meaningful only when you have been through the financial planning process and you and your adviser understand all the dynamics, he says.

Bradley says if you have R100 to invest and need that R100 to grow to R200 in five years, your adviser can devise an investment strategy that, for example, involves investing in equities.

Your adviser can also work out the possibilities and probabilities for that investment and tell you how often you can expect your investment to have a negative return. He can ask you questions, such as how you would feel if your R100 became R80, Bradley says.

During the discussions, your adviser also needs to assess your understanding of the risks, because you cannot assess the risks and make an informed choice about the ones you are prepared to take if you do not understand them, Bradley says.

Du Plessis says that when financial advisers assess your risk tolerance without an objective assessment, they tend to be biased by factors such as your gender, your level of wealth and even your participation in potentially hazardous activities.

He says that industry research shows that:

* Financial advisers’ estimates of clients’ risk tolerance are less accurate than clients’ estimates of their own risk tolerance;

* When clients assess their own level of risk tolerance, they are more accurate than when advisers assess their own risk tolerance (in other words, clients are more in tune with themselves than advisers are in tune with themselves); and

* Advisers’ estimates exhibit gender bias. They overestimate the risk tolerance of men and underestimate that of women. They also over- and under-weight other demographic variables such as income, wealth and marital status.

Your adviser may be tempted to assume that you will accept a higher investment risk if you participate in activities such as bungee jumping, abseiling and parachuting. But it is a myth that risk-taking in physical, social or ethical areas of your life indicates that you have a high tolerance for investment risk, Du Plessis says.

While we behave consistently within an area of risk, we do not behave consistently across types of risk, he says.

So, for instance, a mountain climber is more likely than the average person to be a hang-glider, but he or she may or may not be a financial risk-taker. Someone who parachutes regularly clearly has a high tolerance for taking physical risks but may have a very low tolerance for investment risk, Du Plessis says.

If your adviser gets your risk tolerance wrong, it will not necessarily result in his or her providing you with dangerous advice, he says. But it may result in your being overexposed to risk, and so you will suffer from increased anxiety when markets perform badly. Your anxiety levels may cause you to panic and sell an investment, with dire consequences for your financial and emotional well-being, Du Plessis says.

However, Bradley says that if your adviser does not work out the risk you must take to earn the returns you need to meet your goals, you may be underexposed to risk and earn a lower return than you require, with debilitating consequences.

Du Plessis says your risk tolerance should be determined through the use of questions that are valid, relevant, reliable and not too technical. One example of the questions that should be used is: “Indicate your likelihood of making investment X, given that level of risk.”

Although it is important when providing investment advice to take into account the time horizon of your investment, your age and when you will retire, Du Plessis says these factors do not influence your risk tolerance. Bradley says that while these factors may not affect your risk tolerance, in reality your time horizon will have a significant influence on the investment risk you can take.

For example, he says, a one-year investment horizon in equities could reasonably give you a return of anything between minus 25 percent and 50 percent, whereas over a 20-year period, the returns could range from five percent to 15 percent a year. If you were offered these return parameters on two investment options without being cognisant of the time horizon, you would make a very different decision. These perspectives will have dramatically different consequences, Bradley says.

Du Plessis distinguishes between your perception of risk and your tolerance for risk.

It is often incorrectly assumed that investors have a high risk tolerance when the market is going up and a zero risk tolerance when the market is starting to crash, he says. In reality, your risk tolerance remains largely unchanged, but your perception of risk could change during changing market conditions, Du Plessis says.

While your risk tolerance is a personality trait that involves how much risk you are prepared to take to reach a goal, your risk perception is a cognitive process that involves appraising the risks involved.

Du Plessis cites the example of a rally driver who has a high tolerance for speed. He drives at a very high speed down a straight but reduces his speed when he approaches a hairpin bend. His risk tolerance remains constant, but his perception of the amount of risk involved changes while going into the bend and he therefore reduces his speed.

Your perception of risk is measured by a question such as “How risky do you view investment X?”, Du Plessis says.

The Australian company that has appointed the Institute of Behavioural Finance to market its risk-profiling system in South Africa is FinaMetrica.

FinaMetrica developed the web-based questionnaire in conjunction with the Applied Psychology Unit at the University of New South Wales.

FinaMetrica says the validity, reliability, understandability and answerability of the questions used have been tested, and the questionnaire is designed to ensure that your financial adviser cannot unintentionally influence the outcome.

FinaMetrica generates a risk tolerance report for everyone who answers its questionnaire. The report does not recommend any investments but details your attitudes to risk-taking.

* This article was first published in the fourth-quarter 2011 edition of Personal Finance magazine.