While there is ongoing debate around longevity and retirement income adequacy – goals risk not being met if advisers continue to work with questionable allocation methodologies. One issue that is not getting much attention is the continued focus on risk profiling as a major tool for portfolio selection. Leith Thomas, a director at Bailey Roberts Group, feels that this may be a significant barrier to Australians accumulating sufficient retirement funds.
Preoccupation with risk is limiting retiree outcomes
While risk profiling is a widely accepted step in the portfolio selection process it can be argued that the practice lacks any real value and in many cases risk profiling has been adopted predominantly to tick the compliance box requirements.
Many critics of risk profiling are emerging in the world of academia, pointing to the anomalies that can arise in questioning techniques, such as differing outcomes when the profiling exercise is carried out in differing market conditions and the effects of framing.
Despite this it appears that most critics – and proponents for that matter – miss a key point. Most focus on attacking the errors in questioning techniques that bring about flawed client responses. Very few provide real alternative solutions to these problems and simply conclude that the questions need to be improved.
Even assuming that risk profiling – and in particular psychometric testing – was capable of accurately assessing a client’s risk tolerance, there is no guarantee that it will correspond with the selection of a portfolio that will enable a client to achieve their lifestyle goals, which should be the primary objective.
When it comes to recommending a suitable portfolio, a logical approach is to first establish where the client wishes to go. This typically translates into an income figure the client needs to live the life they want. What this then provides is the ability for an adviser to convert these outcomes into a percentage-based required return, giving a measurable objective.
The required return then forms the basis for an appropriate portfolio selection. Once this has been established the risks of the particular portfolio are importantly then explained and a discussion around risk had.
If the client wants to achieve the outcomes they desire, they need to accept the associated risks. If the client does not want to accept the risks associated with achieving the desired lifestyle, they must lower their expected lifestyle to a level where the risks are more tolerable.
A common analogy likens the risk profiling approach to going to a travel agent for advice on overseas holidays, filling out a risk questionnaire which then discovers one does not like traveling by air or sea.
If they want the outcome, the risks must be accepted so it is either one or the other. Luckily, in this instance it is easy for the client to see that outcomes won’t be met and can make an informed decision on whether to accept the associated risks or not. However, it is not always this clear when it comes to investing, and a portfolio is selected predominantly on the basis of risk tolerance first rather than outcomes.