Risk profiling is arguably one of the most important parts of the investment process.
A valid and reliable financial risk-tolerance test is not only an essential investment planning tool but also an important data point that, when used as part of in-depth discussions about risk, can help the adviser better understand a client’s beliefs and behaviours and ultimately add to the client experience.
From a regulatory perspective, FCA rules state that firms must and are obliged to understand more about their clients’ investment objectives and risk tolerance, so that they can provide them with the most suitable recommendations, based on that understanding.
This understanding enables advisers to help the client achieve their objectives and, vice-versa, it helps the client understand the financial planning and advice process more clearly and brings them more into that process.
That, in turn, deepens the relationship between the adviser and the client and facilitates fruitful conversations.
The concept of risk is undeniably complex, and there are numerous factors that every adviser must consider when objectively assessing a client’s attitude to risk.
Dynamic Planner’s own psychometric risk profiling questionnaire has been used to understand the attitude to risk of more than one million people since 2013, which has provided us with years of data from which to learn.
In this article, I wanted to lean on that knowledge and go back to the basics of psychometric risk profiling: what is psychometrics, why we use questionnaires (and specifically psychometric questionnaires), how we ensure the tools are fit for purpose and whether there are any best practice approaches for firms to adopt when conducting risk profiling.
Background to psychometrics
Firstly, a very quick overview of psychometrics, which is a field of applied psychology that combines concepts from psychology and statistics into tools and techniques to improve psychological measurement.
Some psychometric tests are solely designed to measure cognitive ability, for example most school examinations. Others focus on evaluating personal characteristics and attitudes. Risk tolerance falls within this latter category, using statistical techniques to try to cut through inaccuracies and biases inherent when people answer questions about themselves.
Using scientific principles to study psychological states is relatively new, and only truly evolved in the second half of the 20th century to encompass the measurement and evaluation of personality, beliefs, achievement, and attitudes.
How do advice firms risk profile clients?
While advisers are obliged to develop an understanding of their clients’ objectives and risk tolerance, there is no compulsion to use a questionnaire to achieve this goal.
However, by far the most common approach currently is using a risk questionnaire and ultimately matching clients with investments based upon an agreed risk profile.
Clients complete questionnaires, each answer within the questionnaire is scored and those scores are aggregated, resulting in a final score from one to 10, for example (other systems might use a 1-5 scale or any variant), where one represents the lowest level for risk tolerance and 10 the highest level.