Advisers will be aware Dover discourages risk analysis questionnaires. Our thoughts are detailed in our Friday Reflection dated 23 December 2016, which you can read here: The Pitfalls of Risk Analysis Questionnaires.

You should read this Friday Reflection before you read this practice note.

State the facts: clear, concise and effective

Dover discourages risk analysis questionnaires and instead asks advisers to discuss the concept of risk and return with clients, to explore and explain, to consider each client’s particular circumstances, and what a reasonable financial planner would recommend for that client.

Our default mode is “conservative”. That is, unless your client believes they should not be conservative they should be treated as conservative. If your client believes they should not be conservative, and the facts suggest a reasonable financial planner would agree that the client should not be conservative, then you should treat the client as not being conservative.

You should then state in your SOA, in a clear, concise and effective way, why you believe your client should not be treated as conservative.

An example of a non-conservative investor

Assume your fact finder describes a thirty five year old university educated business analyst, earning say $100,000 a year, in good health, with a good employment record and excellent employment prospects. He is married, with a home worth say $800,000, a home loan of $500,000 and super of $150,000, and a spouse working half-time on, say, $50,000 a year.

These clients will probably tell you they do not want to invest conservatively, and you probably believe a reasonable financial planner would agree that they should not invest conservatively.

So your SOA should contain a series of paragraphs like these:

“Your risk profile

In our meeting we discussed the concepts of risk and return, and you indicated you believe you should not invest conservatively. In summary, I agree with you, and I believe a reasonable financial planner would also agree with you.

The relatively long time to retirement at age 70, your good health, your high, stable, growing and long income, and your reasonable existing asset base, suggest you should be very growth orientated, with most of your wealth exposed to shares and property for at least the next twenty years.

The Russell ASX Long Term Investment Report 2016 says over the last twenty years Australian property and Australian shares have averaged 12.5% pa and 8.5% pa respectively. It is reasonable to expect that similar average returns will be achieved over the next twenty years, and you need to be very exposed to Australian shares and Australian property to benefit from this.

This is reflected in our advice.”

Obviously your explanatory paragraphs and recommendations will differ from client to client, although one expects similar clients to be classified and advised in a similar way.

Being conservative is a high-risk strategy

Most clients should not be conservative, and should be well exposed to growth assets.

The most common financial planning mistakes is to not be sufficiently exposed to growth assets, which is connected to not using an appropriately long time frame.

Most clients will live longer than they expect. A 65-year old woman has excellent prospects of living to age 90, ie another 25 years. Her investment time frame needs to reflect this, and this means she needs to be well exposed to growth assets.

If she is not well exposed to growth assets, and instead invests in defensive assets such as cash deposits inflation and taxation will erode the real value of her wealth as the years go by.

In this sense being conservative is a high-risk strategy. In time clients will lose wealth, relative to the alternatives. Think what would have happened to a 90 year old woman’s wealth if 25 years ago, back in 1991, at age 65, she invested 100% in cash? She obviously would be much worse off now at age 90 compared to investing in property and shares.

Many clients are not aware of this phenomenon, often called “longevity risk”.

A competent financial planner will take the time and trouble to explain and coach their client through this difficult thought process.

Examples of clients who should be conservative

Who then should be conservative? In general terms, we can identify two main types of clients who should be conservative. These are:

  • clients who are not psychologically suited to the higher volatility of growth assets (particularly where the return on growth assets is effectively reduced by the old age pension assets test and/or income test) and
  • clients who need an absolute amount of cash at a particular time and cannot take the risk that it is not available to them.

Clients not psychologically suited to growth assets

Some clients are not suited to risk. The anxiety connected to risk is not justified by the extra additional expected return.

Pensioners are a classic example. Let’s look again at our 65 year-old female client. This time we assume she owns a home worth say $500,000, and has cash on deposit of say $200,000. She does not have any close relatives, and is eligible for a full age pension as a home-owner, including supplements, of about $23,000.

A rational case can be made for some exposure to growth assets. They will over time almost certainly out-perform cash based investments. However, the interaction of the income test and the age pension means the net extra return from growth assets is much less than it otherwise would be. It is therefore quite possible, even very probable, the relatively small expected extra net return on shares and property will not justify the stress of the greater price volatility, and the client will prefer a more conservative investment strategy.

The emotional case beats the rational case, which is sensible when you are advising elderly pensioners.

Here your SOA should say something like this:

“Your risk profile

In our meeting we discussed the concepts of risk and return, and you indicated you believe you should invest conservatively. The higher expected net return is just not worth the higher risk and related stress, particularly after the drop in the age pension is considered.

In summary, I agree with you, and I believe a reasonable financial planner would also agree with you. The stress caused by the greater price volatility is not justified by the relatively low net extra return.

This is reflected in our advice.”

Clients who need an absolute amount of cash at a particular time

The other class of clients who should invest conservatively is clients who need an absolute amount of cash at a particular time and who cannot take the risk of short-term price falls. The classic example is a couple saving for a home loan deposit, or a similar land transaction.

This client must invest these monies conservatively, in cash based investments. (But as we explain in Practice Note 4: Can a client have more than one risk profile, its is possible, even probable,  their other investment monies, for example their super benefits, should be exposed to growth assets.)

Here a paragraph like this works:

“Your risk profile

In our meeting we discussed the concepts of risk and return, and you indicated you believe you should invest conservatively for your non-super assets.

In summary, I agree with you, and I believe a reasonable financial planner would also agree with you. You cannot afford the consequences of a short term fall in asset values and not having the required amount of cash ready for your home purchase.

This is reflected in our advice.”

Table reflecting relative weight to be given to relevant facts

The range of factors to consider before agreeing a risk classification with your client depends on their unique circumstances. In most cases no one factor will be determinative, and your advice, and your client’s decision, will depend on the weight you and your client attach to each factor.

This table is not exhaustive and is indicative only. It helps explain the factors impacting whether a client should invest conservatively or not.

Table reflecting relative weight to be given to relevant facts

Age

Generally the younger the client the more growth orientated they should be. The ABS says most women live to age 84 and most men live to age 80. Obviously many live longer. A 65 year old client can easily live another 25 years.

A client’s awareness of historical long term earning rates

The Russell ASX Long Term Investment Report 2016 says over the last twenty years Australian property and Australian shares have averaged 12.5% pa and 8.5% pa respectively.

Existing wealth levels

Generally the wealthier the client the more growth orientated the client should be

Income level

Generally the higher the income the more growth orientated the client should be

Income stability

Generally the more stable and secure the income the more growth orientated the client should be

Income scalability

Generally the more scalable the income the more growth orientated the client should be

Second household income

A reliable second household income indicates the client should be more growth orientated

Formal education

The greater the client’s formal education the more growth orientated the client should be, particularly if the education involves commercial faculties and or probability theory

Training

The more commercial training the more growth orientated the client should be

Occupation

Occupations that involve commercial judgment suggest the client should be more growth orientated

Family background

A family background in investing suggests the client should be more growth orientated

Previous investment experience

Previous experience with growth assets suggests the client should be more growth orientated

Expected inheritances

Expected inheritances in reasonably short time frames suggest the client should be more growth orientated, depending on overall wealth position post inheritance

Feedback?

Contact Terry McMaster on terry@dover.com.au should you have any concerns about how this practice note applies to your clients or require assistance in any client matter.