Finding a suitable investment - conservative or aggressive is not enough

Laura du Preez | 27 October 2021

Laura du Preez has been writing about personal finance topics for more than 20 years, including eight years as personal finance editor for two leading media houses. 

Many unit trust funds and other retirement fund or endowment portfolios have a label that tells you about the investment risk level.

This is not the same as your risk profile though - your risk profile needs to take into account three factors unique to you and your circumstances. It should then be used to determine a suitable investment with an appropriate level of risk.

This was the finding of a working group made up of members of the Financial Planning Institute (FPI) and the Financial Intermediaries Association (FIA) and published recently in a paper.

In addition to four representatives of the FPI and FIA, the working group included two academics, two investment professionals and four of the FPI’s former Financial Planners of the Year.

The aim of the paper, “Professional investment advice: Risk profiling as a component of Suitability”, is to make sure your financial adviser knows how to determine, and apply, your risk profile when making investment recommendations for you.

You should also understand what a good adviser should do, to ensure you participate fully and get the best advice.

Inappropriate risk levels

It is important to measure your risk profile accurately, Dr Gizelle Willows, an associate professor at the University of Cape Town who has been researching behavioural finance and founder of Nudging Financial Behaviour, says. Willows was speaking at a recent virtual Humans Under Management conference that focussed on best advice for investors.

If your risk is measured incorrectly, you may be placed in an investment with too much risk, or too little risk, which could mean you do not meet your goals, Willows said.

Cases before the Ombud for Financial Services Providers (or FAIS Ombud) have also shown that failing to measure or inaccurately measuring your risk profile can lead to inappropriate advice.

After finding investments with inappropriate risk levels were recommended to complainants, the ombud has ordered a number of financial advisers to compensate investors for their losses.

In many cases the ombud has ordered advisers who sold high-risk investments in unlisted property syndications, to compensate investors for subsequent losses incurred, as the investments were unsuitable for pensioners living on limited means.

The advisers in these cases were found to have failed to establish, or establish properly, the investors’ risk profiles, in contravention of the general code of conduct under the Financial Advisory and Intermediary Services (FAIS) Act.


Product labels are vague

As the FAIS Act does not define the way to establish your risk profile, the FPI and FIA risk profile working group set out to detail how it should be done.

They found that risk level labels on investment products were not helpful. Products are labelled as being risk averse, conservative, moderate or aggressive.

The FPI and FIA working group said these definitions are vague, subjective and fail to consider all the factors you, as an investor, and your adviser should consider when determining if an investment is suitable.


Risk profile defined

The group agreed that your risk profile should reflect the risks that you as an investor need to take to achieve your objectives, given your ability and willingness to accept those risks.

Your risk profile therefore takes into account three factors:

  • The risk you need to take

This is how much investment risk you need to take in order to meet your goals. Typically, your adviser will determine the after-inflation or real return you need to earn – for example, inflation plus 2% (percentage points) or inflation plus 6%.

Then, the asset allocation you need, and particularly, the exposure to the likes of equities, which can deliver that return, must be ascertained. The asset allocation, in turn, determines the investment risk to which your money should be exposed.

The FPI and FIA’s working group suggest that advisers recommending unit trust investments should tell you which fund sub-category has delivered an average annual rolling return in line with the return you need over the minimum term for which you need to stay invested.  

They should then make you aware of associated investment risks by showing you the best and worst annual rolling returns for the relevant unit trust fund category over the long term.

The working group published a table showing the average, and best and worst, returns to June this year for funds in the multi asset, equity and cash categories. Use this table if you want to check the risk level of your investment is appropriate for the returns you need.


Category Minimum term Best return over any 12 months Worst return over any 12 months Best return over the minimum investment term per annum (rolling return over time horizon) Worst return over the minimum investment term per annum (rolling return over time horizon)
Cash 1m - 12m 12,01% 4,04% n/a n/a
SA-multi-asset income 2 years 11,41% 4,31% 9,94% 5,88%
SA-multi-asset low equity (inflation +2% p.a.) 3 years 17,26% -3,10% 11,75% 2,7%
SA-multi-asset medium equity (inflation +4% p.a.) 5 years 24,18% -12,91% 13,08% 4,42%
SA-multi-asset high equity (inflation +6% p.a.) 7 years 30,65% -14,75% 12,55% 4,42%
SA Equity 10 years 48,54% 32,20% 12,19% 5,09%
International equity (AZR) 10 years 52,17% -34,54% 16,95% 7,45%

Data source: Morningstar (31/10/2007 to 30/06/2021)

  • Your risk capacity

After determining the return you need, you and your adviser should check that you can afford to – or have the capacity to - take this investment risk, the FPI and FIA workgroup say.

You and your adviser should check what a fall in the investment value would mean for you – especially if you are retired, no longer earning and relying on the investment for an income.

  • Your risk tolerance

The third element of your risk profile is your risk tolerance, which tests your emotional ability to be exposed to losses.

This is important to ensure you do not disinvest when your investment is showing a paper loss, as you will then realise that loss. However, if you stay invested for the recommended term, it is likely that you will recover your loss as the markets in which you are invested recover.

If you are already invested, consult the table the group published and take note of the worst returns your investment could earn in a year, and whether you are comfortable with that.  

You should think carefully about accepting a certain level of risk when you invest. Your adviser should record your decision and if you change your mind when you actually see a significant decline in the value of your investment and change your investment strategy to your own detriment, your adviser should not be held accountable, FPI and FIA working group warns.


Complete questionnaires with care

Advisers typically use questionnaires to test your risk tolerance. Willows told the Humans Under Management conference that these questionnaires should have around 25 questions, in order to accurately assess your risk tolerance.

They should also not leave you to assess your own risk tolerance, she says.

Your adviser or the questionnaire should establish things that influence your risk tolerance such as your age, gender, dependants and marital status, income, financial literacy and personality, Willows says.

The questionnaire or your adviser should also interrogate your personality type, she says.

A person with high self-esteem, or a sensation-seeker, will be better equipped to handle risk and the anxiety of losses. Similarly, a type A personality – confident, aggressive, impatient and more hostile will have a higher risk tolerance compared to a type B personality, she says.

Most risk tolerance questionnaires rate investors more risk averse than they need to be, she says, which is why you should have a good in-depth discussion with an adviser about investment risk.

Willows says your adviser should make sure you understand how the lifestyle you want and the level of risk you need are related. As an investor, you have to realise that risk is inevitable – if a surgeon asked you if you want to experience pain after surgery, you would say no, but pain is inevitable after surgery and if you need the procedure, you will push through the pain, Willows said.


Professional investment advice: Risk profiling as a component of suitability