I completed a risk analysis questionnaire just now.

It did not take long. Just 15 questions. Each with between 2 and 6 possible answers, and a score for each answer.

Once complete a score is compiled. If the score is low the client is conservative and if the score is high the client is not conservative. Conservative clients get the conservative investment strategy, non-conservative clients get the non-conservative strategy, and in-between clients get the in-between strategy.

Simple. Anyone can do it. Financial planning is reduced to a tick the box exercise.  No need for professional judgement. No need to get to know your client. No need for much time. No need for non-product strategies. No need to discuss things. No need to think.

Simple.

What could possibly go wrong?

Where do I start?

The inherent uncertainty, the incredible subjectivity, the dangerous selectivity and the sheer incompleteness of the survey means a risk analysis questionnaire is, at best, a waste of time. 

Take question 15, for example. It says:

“This table shows the highest one year gain and highest one-year loss on five hypothetical investment portfolios of $100,000. Which one do you prefer?”

The table looks like this:

Investment portfolio

A

B

C

D

E

Highest gain

$11,000

$15,000

$20,000

$26,000

$31,000

Highest loss

-$2,000

-$4,000

$8,000

-$12,000

$15,000

If you choose option E you get 5 points. You are obviously an aggressive investor.

This is really dumb. As it stands, no one, client or financial planner, can answer this question sensibly. No information is provided about:

  • the amount to be invested 
  • the probability of the highest gain and the highest loss
  • what happens in year 2, 5, 10 and 20?
  • what other investments are expected to earn in the same period?

Obviously a rational investor’s answer depends on whether they are investing a relatively large amount, or a relatively small amount, and their assessment of the probability of each possible outcome. Most clients, rich or poor, old or young, smart or stupid, will opt for portfolio E if the amount to be invested is relatively low, say $20,000, and the probability of the highest gain is high, say 95%. Doing so maximises your expected investment gain. Conversely, most clients, rich or poor, old or young, smart or stupid, will opt for portfolio A if the amount to be invested is relatively high, say $100,000, and the probability of the highest gain is low, say 5%, if they were to invest at all. Doing so minimises your expected investment loss.

Why does the question focus on a one-year time frame? What if the second and third year results are expected to be much better? What if the twenty year results are expected to be even better again? This is a terrible short-termism. What client has a time frame of only one year? 

Why does the question ignore what other investments are expected to earn in the same period? What investment occurs in isolation? What if this is the worst performing investment available?

One could go on, absolutely destroying this question. And its just one of 15 questions, some of which have nothing to do with finance and are to do with physical risk taking, as if this was a relevant thought. 

Client’s handwriting?

Financial planners often complete the questionnaire for the client. Now things are getting really dumb. Obviously if things go wrong the client can say “you did not fill out the questionnaire correctly and you got my risk profile all wrong. That’s not what I said…”.

And believe me FOS will believe her, not you.

No validating studies

I am not aware of any validating studies in Australia or overseas which prove that risk analysis questionnaires accurately measure a client’s risk tolerance.

Put simply, there is no science to support risk analysis questionnaires.

What you should be doing

You have to exercise the skill and judgement of a competent professional. You have to advise the client sitting in front of you, not follow a pre-ordained cookie cutter check list. And your advice must be based on facts, not  15 half baked pseudo-psycho questions.

Its all about your SOA, and making sure it stands up to FOS scrutiny and interrogation. If the market falls and your client suffers a loss the appropriateness of your advice will be called into question. You may even have to explain yourself to FOS.

If on the balance of probabilities your advice was not advice that a reasonable financial planner would have given then you will be liable to compensate your client for the loss and interest thereon. Technically the burden of proof lies with the client as the complainant; but, as a practical matter, it lies with you as the adviser.

You must be able to prove that your advice was advice that a reasonable financial planner would have given. The vehicle for doing this is your SOA. The SOA is the record of your advice to your client, and allows your client to decide whether to accept your advice. Here, it is critical that your SOA explains in plain English the facts explaining why you have treated your client as not being conservative. Example paragraphs for a fictitious couple, John and Betty, may help:

“In our meeting you said you believed you should not be treated as a conservative investor and that you should be growth orientated. We discussed this and, in summary, I agree with you. I also believe a reasonable financial planner would be of the same mind. At age 43 and 44 you realistically have at least another 15 years in the workforce. Your incomes are above average, and reasonably secure. The fact that you have two separate incomes reduces risk. You own your home (value about $600,000), have about $200,000 in super and have no debt, and this means your wealth is above average for your age. You are both university educated, and while John has no business experience Betty has worked for small and medium sized businesses and understands that commercial activities involve some risk. You are in good health, and although you have not invested significantly in the past both of your parents are long-term share investors and through this connection you know that share prices sometimes fall in value and capital losses are suffered.

If you have any concerns about not being treated as a conservative investor you should not sign the consent to act form and should contact me immediately.”

Paragraphs like these two, reflecting the client’s individual circumstances, are essential in every SOA where the client is not being treated conservatively. They are needed to properly explain the reasons for your advice, and place responsibility back on your clients to contact you immediately if they do not agree with your assessment of their circumstances.

The facts to be considered will vary from client to client, as will the weight to be attached to any one fact. The list of facts to be considered includes:

  1. age, and generally speaking the younger the client the more growth orientated the client should be;
  2. income. Height of income is obviously relevant. But so are stability and longevity.

    For example, two years ago I argued with an adviser that a 57 year old over-weight truck driver working on a 6 month contract at a coal mine on $150,000pa was not suited to gearing because his income was not secure: few 57 year old truck drivers have a secure and long income in front of them (whether or not they are overweight). I later learnt his six-month contract had not been renewed and he has not worked since.

    By way of contrast, a fit and active 50 year-old nurse on $90,000 a year may be suited to a negative gearing strategy. She is in the 40% tax bracket, has a relatively high income and it’s also stable and secure (there is shortage of experienced nurses). She can reasonably expect to work at least another ten years and possibly a lot more, scaling down the hours if she wishes to, or ramping them up if she is short of cash. She had heaps of accrued sick leave and long service leave too;

  3. the diversity of income. Situations where both partners work generally mean their future income streams are less risky compared to where there is only one income;
  4. the existing wealth level. Generally speaking the higher the existing wealth level the more appropriate a growth-orientated strategy will be. If a 43 year-old client owns a home worth $600,000 and has $200,000 in super, placing the super in high growth investments may make a lot of sense. Gearing it up may make a lot of sense too. Appreciate that this means overall only 25% of her assets will invested non-conservatively (we regard debt free homes as being conservative assets) and the overall mix is still reasonably conservative. Make sure your SOA stresses this point;
  5. education levels. Generally speaking the higher the education the more the client should be investing for growth, given that they are more likely to understand the ramifications and implications of their decisions, particularly the possibility of capital loss and the role the uncontrollable general economy plays in investment outcomes;
  6. training. This is similar to education. For example, a client who has worked extensively as a manager in small businesses and has, say, a certificate IV in small business management cannot claim to not understand that share prices can fall and capital can be lost;
  7. previous investment experience. If a client has invested heavily in direct shares previously, and had profits and losses, this suggests suitability to growth orientated strategies; and
  8. health. Clients with health issues should normally only invest conservatively, as their health issues mean they may not be earn a living by working and may not be able to recoup any losses.

None of these eight criteria is determinative. In some cases some criteria will decide the day, and in other cases other criteria will decide the day. It’s a case-by-case analysis, and each time the individual client’s facts have to be detailed, and set out in the SOA, along with your thoughts and comments. Assume that FOS will read your SOA. So think about what you want to have on the record for FOS to read. You have to show that your advice is advice that could be provided by a reasonable financial planner and is in line with established norms.

If in doubt, stay conservative.  And say why in your SOA.

What if your client says he thinks he should be a high growth investor? 

The client’s view of things is important, of course. But your view of things is more important. You are the adviser, and it’s your advice that will be reviewed by FOS and may be the object of a damages award. You have to form and write down your professional opinion. It’s no answer to say: “the client said he was high growth” when a reasonable financial planner would not have agreed. Here it’s your job to say “no”. If a patient attends a doctor and says, “I have a sore arm could you please cut it off” this does not mean that the doctor can cut off the patient’s arm without further investigation. It does not work like that. The patient’s opinion of what is wrong and what the cure should be is of only minor relevance. The patient is not the doctor. The doctor’s duty of care requires her to go through an evidence based process including accessing further information and opinions if appropriate before drawing on her own training and experience to diagnose the condition and prescribe an appropriate cure. Every doctor knows they need to be healthily skeptic about what patients say. Patients often get it completely wrong and sometimes just say what they think the doctor wants them to say. Sometimes patients even tell lies. It’s no answer to FOS to say “…but the client said she was high growth…”. Your SOA has to set out clearly why you thought she was high growth, and why a reasonable financial planner would agree with you. 

What if your client does not accept your advice? 

What if your client wants to invest in high growth investments, and you do not think this is appropriate, but your client nevertheless insists…? Here I suggest you use a paragraph like this one:

“You said you wanted to invest aggressively, using debt, because you are getting older and it is “now or never” and you need to catch up fast. I explained that most financial planners would disagree, and that my advice, based on your age, your low level of wealth, concerns about the stability of your employment and your general circumstances was that you should be very conservative and definitely not invest aggressively using debt. You have not accepted my advice and you have instructed me to facilitate the investments set out below. I will accept these instructions on the strict understanding that I have not recommended these investments and I am not liable in any way for any losses or costs incurred in respect of them.”

In other words, your SOA has accurately recorded your advice.

In summary

Dover strongly discourages risk analysis questionnaires.

They are biased devices designed to induce clients to overstate their readiness to take on risk.

ASIC does not like them, and FOS does not like them.

Risk analysis questionnaires are full of leading and misleading questions and historically they have been mis-used to help sell dodgy products. Most Westpoint “investors” completed RAQs saying they had a high propensity to risk… it was part of the sale pitch… It was cruel.

If you use them you still have to set the facts supporting your reasons for the client not being treated as conservative and, if the facts conflict with the questionnaire, the facts have to win out.

In other words, Dover does not care what the questionnaire says if the facts do not agree. A questionnaire is not a substitute for an informed and reasoned professional opinion.

Dover requires informed and reasoned, and recorded, professional opinions carefully set out in every SOA. No exceptions.