Miscalculated risk

By BRENT SHEATHER

Working out how much risk a client can handle is one of the most important tasks an investment adviser performs but, judging from the number of unit trust investors who sell after the market falls, it is as much an art as a science.

"Risk profiling," as they call it in the trade, is a tough call at the best of times because an investor's and their adviser's tolerance to risk changes - veering between greed and fear depending on the circumstances.

In 1999, when US shares only went up and anyone with bonds was a wimp, a typical balanced portfolio from a financial planner had 60 to 70 per cent of its money in shares. Today, many investors are chastened by the experience of losing 30 per cent or so of their capital and have embraced fixed interest with the same fervour they once had for technology stocks.

Compounding the problem is the fact that individuals - advisers and clients - are usually most keen on taking risky positions when the relationship between risk and return is least attractive. That's because, against all advice, they assume past performance will continue and buy when historical returns look great, prices are high and prospective returns are low.

Try selling an international share fund like WiNZ to someone today, when its track record shows that it has fallen by 23 per cent a year for three years - it's not easy, believe me. You'll have far more success with New Zealand shares, bonds or residential property.

The odds that your portfolio will accurately reflect your risk profile are diminished further by the fact that most advisers get paid more for selling higher-risk investments than for those which are less volatile. In that sort of environment it's not surprising that financial advisers' success or otherwise in determining clients' risk profiles is increasingly coming before the courts.

This month the Financial Planning Association of Australia published a "policy position" on risk profiling and risk tolerance which refers to a case which came before the New South Wales Supreme Court.

The court found a financial planner legally liable for failing to properly identify a client's investment needs and risk profile.

The association's policy position is an attempt to improve the management of risk by its members and avoid further bad publicity for the industry.

Key conclusions in the paper are:

* The more knowledge and experience a person has, the less fearful they are of risk and more capable they are of making an informed decision.

A financial planner's role is not to avoid investment risk altogether but to assist clients to learn to embrace and manage reasonable investment risks to achieve their desired investment goals over realistic and relevant time frames.* A common practice has been to classify clients into categories along a spectrum typically from "Conservative" to "Aggressive".

After consultation, the association believes that "risk profiling" and resultant pigeon-holing are contrary to the concept of tailored and customised advice. It is yet to be proven that the processes used for categorising clients are robust and that short-term market performance or the current political and economic environment does not affect attitudes.

Furthermore, a client's actual circumstances and objectives may be in conflict with their expressed attitudes and preferences. For example, an "aggressive" investor requiring all of their capital in the short term may be well advised to have a conservative portfolio despite their aggressive attitudes. Conversely, a client with a very long time-frame would not be behaving aggressively by choosing to use primarily market growth assets.

* Best practice will include evaluating the downside risk to both capital and cash flow in the short term and also over the period of investment. Advisers will consider the implications of poor performance on the financial well-being of clients and advise the clients of these risks in terms that are easily understood.

There are two particularly important aspects to all that. The first is that the association criticises the common practice of putting clients into broad categories such as "aggressive" and "conservative".

The second is that it distinguishes between cash flow - the actual income an investment produces, such as dividends and interest payments - and capital volatility - the changing value of that investment.

That second point has major implications for the industry both in Australia and this country because when financial planners work out their spreadsheets to forecast how much a portfolio will produce in retirement, they typically lump volatile capital gains in with more predictable interest income and dividends.

Given the problems with risk profiling, it may be worth asking why bother, and explore other commonsense alternatives instead.

The main point of a risk profile is to decide how assets should be allocated - what proportion in "risky" shares, and how much in "safe" fixed interest, for example. But the question that retired investors seem to be most concerned about is more basic: "Will I have enough income to live on?"

If a portfolio is set up so that all the client's income needs will come from interest and dividends (barring a depression) it seems that the volatility of the capital sum is less of an issue.

On this basis, the asset allocation of many retirees, other than the seriously rich, is limited by their income needs. No matter what their risk profile is, they just can't afford to have too much in investments such as international shares or hedge funds because the income they yield is so low and uncertain.

Where clients and their advisers frequently get into trouble is when they calculate income without making a distinction between low-risk interest payments and dividends, on the one hand, and more volatile capital gains.

No matter how diversified it may be, any portfolio which requires the sharemarket to consistently rise by 5 or 6 per cent a year to deliver cash for living expenses is high risk, plain and simple.

* Brent Sheather is a Whakatane investment adviser.