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Asking the right questions

This article is part of
Risk Profiling - July 2013

In the past 10 years the growth in the use of risk-profile questionnaires has been dramatic. It would be hard to argue that this has not been a good thing and of benefit to investors, but there have been a few ‘bumps in the road’.

One well-known and widely-used risk questionnaire had to be withdrawn completely as a result of the FSA’s review because it was poorly constructed and a number of advisers using it found they could not defend themselves from complaints to the Fos. Advisers have since been careful to undertake some due diligence before adopting a questionnaire.

So how does a risk questionnaire fit into the advice process? A good psychometric risk-profile questionnaire gives a statistically reliable profile of an investor’s attitude to investment risk in general at a particular point of time.

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This is, of course, an excellent starting point to the advice process. However there are lots of caveats and things to consider. For example, it is well known that people generally have skewed perceptions of risk. We give dramatic outcomes much greater attention than more frequent smaller calamities. A good example is the perceived risk of flying compared to travelling by car. In both cases there is the risk of death, although far more people are killed or injured on the roads than in plane crashes, but a single plane crash, in which a great many lives can be lost, causes people to consider flying as riskier than road travel.

The private investor’s perception of investment risk is subject to similar biases. For example, large falls, (often temporary) in stock markets are given much greater attention than the steady (and normally irreversible) loss in the real value of savings due to inflation, so considerable care must be taken when interpreting the results from a questionnaire. It is important to give the investor a balanced picture and to try to help with the understanding of investment risk but, here again, care is needed. How investment issues are explained can have a strong influence on decisions.

Much work has been done by behavioural finance academics on people’s attitude to making investment decisions. How an investment choice is presented to an investor, or ‘framed’, can have a very considerable effect on his decision. For example, an investor will be more attracted to an investment presented as offering a 90 per cent chance of making some money or at least preserving capital than one described as having a 10 per cent chance of losing money, albeit that it is the same investment.

As this example illustrates, investment risk tends not to be viewed symmetrically by the private investor. Potential losses are given much greater weight generally than gains. So advisers need to be very careful not to influence their clients’ perceptions of investment risk.

Worse still investment risk is multifaceted. Even the risk of capital loss is dependent on the investor’s time frame. Then there is liquidity risk, that is not being able to sell the investment when required or the risk of poor performance due to lack of diversification. This latter risk is particularly important if an adviser is recommending a risk-rated fund.