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Are You Investing Yourself Poor?

May 24, 2023 | Financial Planning | 0 comments

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If you have completed a risk profile questionnaire with a financial adviser, on the basis of which your money was invested, you may have made a big mistake!

South African regulations simply tell advisers to determine the risk appetite of their clients and use whatever means they choose to do so. At Veritas, we see this tick box approach as being potentially very dangerous for clients.

Risk profiling questionnaires are highly problematic for a few reasons:

  • They do not take into account that investors generally have little experience in this. It is a big ask to expect them to understand their ‘appetite for risk’ as this can be quite subjective.
  • They do not consider that your appetite for risk changes. For instance, if you have just lost a sum of money, you will naturally become more conservative. If your investments have done well for an extended period, investors tend to become “aggressive” investors.
  • Most importantly, risk profiling fails to bring home the true impact of investment risk. This not only leads to unrealistic investment return expectations, but leaves investors highly disillusioned when their financial goals cannot be met.

In a recent survey,  a group of 50 people were asked whether they considered themselves conservative, moderate, or high-risk investors.   Sixty percent described themselves as moderate, 20% said they were aggressive and 20% conservative.

Some of those who described themselves as moderate risk takers expected to receive 15% to 25% on their investments per annum, while some conservative investors expected a return of 15% to 20% per annum!

With these assumptions, and no expectations being set, there will be a lot of disappointed investors.  Statistically,  the JSE has returned 14% a year over the long term (20 years +).  This demonstrates that investors generally have a poor understanding of the relationship between risk and returns.

 Helping you understand investment risks 

We believe that a far better way to help you understand the risk of a particular investment is to provide you with the expected range of returns over a specific time frame.

If you are simply told that the value of your portfolio will decline by 25%, most investors would stay out of the market on the assumption that they will lose money.

On the other hand, if investment time horizons were discussed upfront, and you were told that the value could fall by 25% within a short period, but then recover over time to meet your mandated return, this would be more acceptable. The important thing to understand is the extent of possible short-term fluctuations and, critically, the time period involved to be invested to meet your targeted return.

A range of returns will show what an investor can expect to achieve over a time period. Bear in mind that negative returns are not permanent losses of money, but are fluctuations in the market due to market events.

Starting your financial plan based on a risk questionnaire can potentially set you up for failure.

An example of the danger of using risk to drive investment planning would be if you were to tell your financial planner that your risk appetite is such that ‘I never want to lose money over any one-year period’.  On this basis, you would be advised to invest in a money market fund.

But the consequence of this can be dire for your long term financial security. Although you will never have a negative return. you would receive a negative investment return after inflation and tax. You would essentially be saving yourself poor – this is the real risk of investing too conservatively.

The ultimate danger of risk profiling is that it could affect your lifestyle much later in life, by which time it would be too late to rectify.

The Veritas Solution

The correct starting point when considering whether to invest is to identify your and your family’s financial and lifestyle goals.

After all, what is the point of saving and investing every month?

Once we know what your goals are, the funds you have available to invest and your time frames, we can calculate the minimum rate of return required to reach your goals. The return is based on a target above inflation, which is expressed as anything from inflation plus 1% to plus 6%.  We call this a targeted or mandated return.

Only then would we discuss the investment risk of the mandated return you would need to assume, in order to achieve your goals.

We believe the right way to demonstrate the risk of your investment  is to show the range of returns you can expect, from a specific mandated return, rather than asking what your personality type is or asking you whether you are a low, moderate or high-risk taker.

If your mandated return is inflation plus 5%, you can expect that your portfolio could decline by up to 19% in any one year. If you are not comfortable with this, we go back to the drawing board and discuss which of your lifestyle goals you are prepared to compromise on and calculate a new required return.

The graph below for a CPI + 5% strategy shows that the longer you remain invested, the lower the chance of a negative return, and the more certain a positive outcome.  

The horizontal axis shows the investment horizon in years, while the vertical index shows percentage returns over the relevant time frames.  

The benefit of showing the range of returns is that, before you commit to an investment strategy, you then understand the time frames involved and the risks of a negative return. This could mean that, in any one year your investment return could range between -19% and 44%.

The shorter the time frame, the more extreme the potential shorter-term losses and gains are likely to be, but the band of returns narrows over longer terms. This is why you should not panic about short-term fluctuations.

At Veritas, our robust lifestyle planning process will not only help you achieve your goals but help you to fully understand the investment risks and be comfortable with them before committing to an investment.

You are welcome to have a discussion about risk with your financial planner at your next review meeting.



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