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If you had invested $100,000 in December 1979 into the Australian Share Market or had invested the money into term deposits, how would the investments have performed? Had you reinvested the dividends from the share investments you would have had nearly $3,000,000 in the investment. The term deposit with interest reinvested would have turned out to be about $627,000. Is $2,400,000 difference noticeable?
The graph above represents the Strategic Asset Allocations as recommended by Van Eyk Research as at 15th September 2001. (see Investments -Investor profiles) The table below the graph shows the return that would have resulted from the above allocations over the period from July 1975 to July 1999. the difference in returns on $100,000 invested conservatively versus Aggressively over that period of time would be as follows
Sure..... past performance is no guarantee of future performance but are you prepared to bet against the share-market outperforming Term Deposits over the next 20 years? TAKING THE RISK OUT OF RISK There are some ‘risks’ inherent in all investments. Investors need to understand the risks they are taking so they can properly assess the returns expected from their investments. Similarly advisers need to consider a client’s tolerance or aversion to risk, when formulating appropriate investment strategies and product recommendations. This forms an important part of meeting your obligations under PS 122 and section 851 of Corporations Law – ‘Know your client’. Advisers have an implied general standard of care obligation to consider a clients tolerance to risk when making a full needs analysis of a client. This extends from the ‘Know your client’ rule. Financial Planning best practice also provides consideration to a client’s tolerance to risk in the financial planning process. (This was evidenced in a report commissioned by the FPA in 1996 conducted by Professor Birkett to examine ‘competency standards for financial planning’). Risk Disclosure There is also a duty to disclose investment risks as being implicit in the general obligations of licensees to conduct business efficiently, honestly and fairly. The FPA’s Rules of Professional conduct – Rule 111 provides that ‘in preparing oral or written recommendations to clients a member shall provide an explanation of the nature of the investment risks involved in terms that the client is likely to understand. The FPA released a Practice guideline (No.2) specifically dealing with disclosure of investment risks and investment strategies. A financial planners role is to not to avoid risk altogether but to assist clients to learn to embrace and manage reasonable investment risks to achieve their desired investment goals over realistic time frames. A client’s capacity to accept certain investment risks would normally be dealt with during the course of collecting sufficient information about the individual’s circumstances. What is the most appropriate risk profiling system to ascertain a client’s tolerance to risk has been debated in the financial planning circles for many years. The FPA conducted a study late last year involving its principal members. The study explored the methods that members are currently adopting to assess a clients tolerance to risk and highlighted the possible flaws in some methods. The study showed that there is no single dominate methodology used in the financial planning process to assess a clients risk tolerance. The industry currently assesses client risk tolerance in a number of ways. This includes providing a clear description or quantification of the potential risk associated with any recommendations, a process of educating the client, diagnostic questionnaires and other methods of assessing a clients ‘risk profile’ and comparing and contrasting that profile with the ‘risk profile’ of the recommendations. Such risk profiling is done within the industry currently using a range of manual and computerised processes with varying degrees of sophistication. Pick a point The simplest of the manual method requires a client to ‘pick a point along a line‘ indicative of their risk tolerance. This method may be flawed as the client may not fully understand the concept of ‘risk tolerance’. Q&A Another method is to use Question and Answer type questionnaires, such as a ‘select one in five investment profile’ – where a question and answer questionnaire is filled out by the client and a score is obtained and used to select a one in five ‘investor risk profile’ where each profile has a particular asset allocation. A danger occurs where no assessment of the clients tolerance to risk is undertaken, and the financial planner uses the questionnaire to drop clients into one of the built in five asset allocations boxes. The whole financial planning process boils down to how the client answers a few questions in a scored questionnaire. Lifestyle questionnaire Care must also be taken that each investor is assessed as an individual, and should be treated as a person with unique needs and attitudes. Some ‘life style approach questionnaires’ may encourage the view that clients of the same age group and employed in similar professions are at the same point in their life cycle and planning horizon. Tolerance testing Computerised tolerance–testing tool. Such tools must be rigorously developed, be thoroughly tested, ask specific risk tolerance questions, and allow for gap analysis- an analysis of the clients current position, their level of resources, their financial goals and how those goals can be met given their time frame and risk tolerance. A review of leading financial planning software systems has indicated that risk profiling questions have been incorporated in their financial planning systems, designed to assist clients in determining their risk profile and what type of investor they can afford to be, based on their personal preferences and life situation. It should be noted that this would not reduce the onus on a financial planner to identify the particular investment risks associated with specific recommendations. Education One of the most important factors influencing a clients’ risk tolerance is their level of understanding of financial matters. As in most cases, the more knowledge and experience a person has, the less fearful and more willing they are to undertake risks. Advisers are in the best position to explain and educate clients on the risks associated with the recommendations being made. As there are many methods that one can employ to research investment products there are also many methods to ascertain a client’s risk tolerance. It is important to emphasise that whatever the method used, you should ensure that you discuss with your client how the profile has been derived, and their perceptions of the conclusions. Written by Christina Kalantzis Manager Policy & Professional Standards Financial Planning Association of Australia Limited To get a copy of a questionnaire used by ProQuest click here A number of articles have been produced to educate people about investing for the purpose of creating long term wealth, some of these articles can be viewed by clicking on the links in the table below.
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