Psychometric risk profiling de-mystified

Successfully agreeing a client’s attitude to investment risk is one the most important, and most vexatious areas of financial advice.

Indeed, most of us who have been in the industry some time can remember situations along these lines: we carefully explain risk to clients at the time of recommendation, and some years later, usually after a market fall, the same client who insisted on that medium risk fund is suddenly upset that they were not recommended something more cautious.

Ultimately, nothing can prevent this situation from occurring from time to time.

However, advisers large and small have turned to more sophisticated methods of assessing client attitudes to risk to reduce the possibility of it happening.

These methods generally centre on the practice of psychometric risk profiling. However, it is crucial that advisers using these methods understand what this type of risk profiling does, and as importantly, does not do.

Essentially, psychometrics is an internationally recognised method of assessing an individual’s knowledge, experience, attitudes and personality traits; in short it measures how people feel about risk, as opposed to how much they can afford to lose or how much a given portfolio might lose.

As such, psychometric questionnaires tend to steer clear of hard numbers (i.e. how much can you afford to lose) and instead focus on areas such as desire for profit, suggestibility and tolerance for ambiguity.

The questionnaires are validated based upon a sample of the UK population (1,023 people were questioned in our work with the Psychometric Centre). This means that the questionnaire is statistically valid, which is not the same as a perfect predictor of a client’s attitude to risk.

Indeed, I am sometimes challenged along the lines of “I took the questionnaire and actually, my preferred attitude to risk is different from the answer”. These challenges are in fact an example of the process working. The questionnaire has provided a framework and a starting point to think about risk, not a substitute for the respondent making an active decision on the issue.

In fact, the best way to use the questionnaire is to communicate the answers to the client, explain the financial consequences (most risk profiling software provides information about the consequences of risk as well), and invite them to validate the conclusions.

Used in this way, the fact that the client has been given the means to make an informed choice about their risk tolerance can be unequivocally demonstrated, with obvious benefits for all concerned.

Simon J Farrant, APFS, Chartered Financial Planner is Head of Financial Planning at Distribution Technology Limited.

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