If you have ever invested money in a fund or collective fund with a 3rd party, either through a pension or through an investment structure (product or platform) you will most likely have already completed a ‘Risk Questionnaire’ or ‘Risk Survey’. It may have formed part of the bigger conversation about your investment goals, or it may have been the sole basis on which you made your investment decision. If it was the latter than there may be cause for some concern.

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The Conflict:

If an individual seeks financial guidance they generally do so in good faith that the person they seek it from will have their best interests at heart. In a recent interview with Eric Brotman we explored what the term Fiduciary meant, and it means. In essence it relates to the relationship between a financial advisor and a client as being one established on trust, and where the advisor is bound by a responsibility to act in the best interests of a client. That is to say that they place the client’s interests before their own……which for many people in Ireland will seem like a strange idea.

When we seek any help, whether it is to buy a car, have some domestic appliance fixed, book a holiday, visit a physio, hire a painter, as a nation we expect that the person(s) providing the product or service to be acting in their best interests and will perhaps try to sell us or charge us more than may perhaps be strictly necessary…..it is a cultural thing, perhaps in every corner of the globe.

To suggest then that a ‘financial advisor’ would not act in their own best interests, to act in a fiduciary manner, seems almost alien, and totally counter-intuitive! Yet this is a formal means of working for a small yet growing population of financial services professionals in the US. I, for one, am looking forward to the growth of such a population in Ireland….perhaps it starts right here.

Need Versus Wants:

You are perhaps wondering what any of this has to do with Risk Questionnaires, thanks for bearing with me. Lets image a scenario where you are a 60 year old with €250,000 sitting in deposit accounts but who now needs to generate an income of €15,000 per year (6% of fund) from your investment in order to pay for the lifestyle you maintain. In addition you want to have that income increase in line with inflation each year, your circumstances demand it.

If you seek financial guidance on the matter in Ireland, despite the fact that you clearly and without prompt announce that you want to generate €15,000 per annum from the €250,000, the very first thing that will likely happen to you is that you will have a ‘Financial Questionnaire’ cast before you. You will be asked to complete this questionnaire on the promise that all will be revealed once complete. It will generally precede any other logical conversation. Despite the ‘need’ you have so articulately expressed at the outset a recommendation will be made based purely on your questionnaire results….’the computer says a,b,c or d’!

And speaking of results, if you are a 60 year now you may have previously built up some reasonable wealth, perhaps sizable value of shares in a few banks here, perhaps an investment property or two. Needless to say you may well have seen your property portfolio fall in value by 50% which has since recovered a little but was a harrowing experience, and indeed perhaps you lost your entire investment in said bank shares in the years 2008-2011. You are once bitten and twice shy. As a result your answers to the questionnaire lean to the very conservative side, and you score ‘low-medium risk’ level. The advisor will therefore generally make a recommendation that you invest in ‘low-medium risk’ investment, which he or she deems is more suited to you that a ‘high risk’ option. On the face of it what you as an investor want is a ‘low risk’ portfolio, however this is not what you need!

If you as an investor follow this recommendation of a low-risk investment portfolio you will unfortunately never reach your long term goal for this investment. Using Monte Carlo simulations (which runs a thousand different market scenarios over the term) we have assessed the mathematical probability of you actually getting this income for any significant period of time from a portfolio such as this, and it is not encouraging.

Assuming long term inflation of 2.5%, a blended fixed income/bond portfolio generating average 3.4% return, and applying an investment fee of even a relatively paltry 1% there is a mathematical probability of 0% of you receiving €15,000 per year for the next 30 years.

Indeed it stands a 0% probability of lasting 25 years also. There is a 45% probability of it lasting for 17 years……..that’s less than a 50/50 chance of you still having this income at 77 years of age. What you are to do after that is a mystery……The recommended portfolio will result in you more than likely running out of money well before reaching 78 years of age, it is wholly and utterly unsuitable to your actual needs, whatever about your wants!

Deeply Flawed :

At the risk of calling a spade a spade, this questionnaire is more-so a tool by which firms use to avoid being successfully sued by clients who might in future (when the market happens to be in a temporary decline, never it seems while on the upward curve) claim they were sold an investment that was unsuitable and/or unnecessarily risky. This has happened before many times, quite often on merit, and is essentially the blasted reason that these questionnaires are now so prevalent, and more so that there is so much weight given to the results of them, despite them being so heavily flawed and irrelevant.

The dog on the street knows that the recommendation is a waste of time, that it will not deliver the result needed. If the profession of financial services does not deliver results then why on earth does it exist! What you as investor (in this hypothetical scenario) need is 6% growth per year in order to satisfy your income and legacy needs. However based on your answers you only apparently want to invest in a portfolio that will deliver -0.1% after fees and inflation!

Sufficient Income:

If you were today looking back on the past 100 years and were offered a portfolio that has delivered average returns of 9% percent per year over that period, another that delivered 6% per year, and another that delivered 3.5% per year, which would you pick? Most people would select ‘option A’ there! If you were then told that option A could had temporary declines of approximately 30% every 5 years, option B had temporary declines of 20% every 5 years and option C had temporary declines of 10% every 5 years, are you still sticking with Option A? Perhaps you are or perhaps you are not. Either way it’s secondary to our point of this piece.

If you need to get a 6% income every year from something, which option would you pick, A, B or C? I would bet the house (and I don’t gamble!) that very few would pick option C. Indeed based on my interactions with people they would pick option A, provided they had someone to hold their hand and assure them the next time it falls by 30%, which it surely will!

Option A, in this scenario is a globally diversified portfolio of companies. Take for instance the Vanguard Global Index, which holds, in 1 index fund, over 1,600 companies of merit and considerable power which has delivered considerable growth to investors. Yes it will be exposed to a temporary decline of 30%+ over the coming years (we’re not into projections but it is statistically highly likely), and yet the likes of this fund have delivered 9% for patient and stoic investors who hold their ground both when it is up 50% in 24 months and indeed the reverse!

Despite these temporary declines using the same Monte Carlo simulation buy running it based on an investment in a highly diversified, equity portfolio, the same €250,000 has a 74% probability of getting you to 77 years of age!

If we really push it to the limits we have to project that you will live till 87 years of age before the probability drops below 50% of that €15,000 annual income not being there, if invested in a portfolio that is ‘risky’, that the industry tells anyone over 50 years of age is ‘too risky’ for them. So as the real impact of that is felt, that is an equal probability of getting an additional 10 years of income beyond the ‘safer’ portfolio. 10 year of income which is growing each year with inflation, which if you are interested will mean you are drawing €29,217 per year in 27 years time (up from €15,000 today).

In fact, to be in anything other than a dividend-earning, long term growth fund is risky if an income which increases with inflation every year is your goal! In this instance risk is the likelihood of you not achieving your plan.

Conclusion:

6% is a sizable income to be hoping to take from anything over a 25-30 year retirement, and particularly so when you factor that you wish that income to be increasing each year in line with a projected 2.5% inflation rate, as we have done in these scenarios. However, if that was what you sought the statistics suggest that to try and do so in anything other than a portfolio such as Option C is a hiding to nothing. We are not in the business of projections, or of predictions (we don’t even know if we will be waking up tomorrow!) but we are believers in the long term and enduring power of the constant upward curve, as history has shown us….not some computer generated questionnaire which does little more than tick some boxes.

Thanks For Reading,

Paddy Delaney

QFA| RPA | APA | Qualified Coach