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Chris Gilchrist: Scrap your psychometric risk questionnaires

The more I think about psychometric risk questionnaires the less useful they appear. My view is advisers would do better to dispose of them and spend more time thinking about risk capacity.

Purveyors of psyquests will tell you their questionnaires are constructed to give consistent results. Your client will emerge with the same attitude to risk next year as today. They claim they are measuring a stable personality trait.

As Keith Armstrong makes clear in a recent paper on risk (available from keith@arm-strongfinancial.co.uk), the designers simply assume the trait exists and then set about creating measures. The academic literature provides no convincing evidence for such a trait. Moreover, if the trait never changes, what can it usefully predict?

Faced with the evidence of clients’ changing tolerance of risk, the psychies say people’s perception of risk changes in response to events and that their appetite for, or tolerance of, risk therefore changes also. But the attitude to risk derived from the psyquest is not predictive of such changes, their direction or magnitude. So what use is it?

The answer is that you can map the five, seven or 10 ATR profiles derived from a psyquest on to a similar number of profiles corresponding to an asset allocation mix. This is what most risk-profiling tools did until the FSA issued its warning last year. Now they do not make such a direct link – or they wrap a lot of cautionary blurb around the process.

As Armstrong asks, what is the logic of this mapping? Why does someone who has an ATR profile of three get a cautious asset allocation? What justification is there for saying this ATR is consistent with a 30 or 40 per cent exposure to equities?

The answer is there is none, the two scales are simply made to fit onto each other. You can divide the ATR into as many segments as you like, likewise asset allocation mixes. Depending on the assets you choose and the way you measure volatility – weekly, monthly or quarterly – you will end up with a different risk-return map. Depending on how you weight answers to the questionnaire, you can allocate people to an ATR of three, four or five on a 10-segment scale. Neither scale is scientifically validated or supported by any convincing practical evidence.

All you can say in favour of psyquests is that they confirm what a good adviser knows as a result of knowing their client but they do not validate any specific asset allocation for a client any more than the adviser’s knowledge of their client validates it.

The best determinant of a suitable asset allocation is not attitude to risk but capacity for loss or for a shortfall from what is needed to meet a client’s goals. I was interested to note the process created for Sanlam by Rick Eling uses the crunch question on what level of loss the client can accept to override any input from the adviser or the psyquest.

This is the correct approach and I expect more advisers to adopt similar methods once they realise psyquests do not protect them from client claims for losses due to taking on more risk than was appropriate.

Chris Gilchrist is director of FiveWays Financial planning. He edits the IRS report newsletter and is the author of the Taxbriefs Guide, The Process of Financial Planning

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Comments

There are 9 comments at the moment, we would love to hear your opinion too.

  1. man on the moon 15th June 2012 at 10:41 am

    No doubt the same FSA will change their minds again on what they consider good practice.

    Previously it was good practice to use an ATR q’aire/psychtest with an asset allocation model following on.

    Sic Pension swithing review doc.

    An Advisor always needs a healthy dose of realism in all matters and this is just another one.

    Sticking 15% in commercial property is not always a great idea as some AA models suggest nor sticking 80% in UK fixed interest when it is historically over priced.

  2. Interesting article but misses the starting point. We need to define what risk is, how this is perceived through the eyes of the client first and foremost. Risk means different things to different people, we therefore have a need to;
    1. Ensure advisers are well equipped to ask the right questions
    2. Any ‘tool’ that is used has to be supported empirically
    3. Advisers have to understand their own definition and tolerance to risk to avoid ‘transference’
    4. Behavioural economics needs to be understood, explored and applied to ensure loss aversion, disposition and mental accounting are managed.

    Only then can we gain a better insight into the clients views around loss capacity and ultimately their informed consent. If you don’t have this at any stage, then walk away.

  3. Baby and bathwater comes to mind. I have some sympathy with your perspective, but ATR questionnaires are tools and an aid to a proper discussion. As with all things, some are better than others. The better tools all make this very clear as have the FSA.

    You are absolutely right to raise the issue of capacity for loss, but be warned that this too is somewhat wooly… in reality you could lose everything and live in a tent…but great financial planning (and I mean proper planning!) identifies what a client needs to support their selected lifestyle – generating their number. You can bung in plan B, C and D if you like to model doomsday scenarios and still identify how much is enough. This then informs the required investment return (which may even be negative!) which then prompts the question, not just how much risk, but why take any! (for those in such a position)… the tools merely help the discussion, they are not meant to be prescriptive. An advisers professional judgement will then inform what action to take, but be warned, chasing HNW clients and basing your revenue stream on FUM may prove a bit silly if your impartial result is – reduce investment exposure. So the real risk warning is failing to do the planning properly in the first place and then failing to identify what return is really needed.

  4. Risk is defined thus “expose (someone or something valued) to danger, harm, or loss”

    So by allowing us to being born, our mothers and fathers have deliberately exposed us to risk, so we should sue them for bad advice, it would have been safer to reside in our mothers tummy ad infinitum and not grow up into an adult, able to make decisions and of course live with the consequences of those same decisions.

    Still, that’s life innit!

    Too much hooey, not enough common sense.

    The old analogy of what the man on the Clapham omnibus would think still applies.

  5. If you focus on the ATR Chris then you have lost the plot no ATR is enough on its own. An investors risk tolerance generally remains stable what has changed is the investor’s perception of risk, and that is why the discussion is so important – the real story here which you missed was just how can a web site replicate the conversation that the regulator is so keen on? In determining suitability.

  6. “The more I think about psychometric risk questionnaires the less useful they appear. My view is advisers would do better to dispose of them and spend more time thinking about risk capacity.”

    Risk tolerance (the level of risk the client would prefer to take), risk capacity (the level of risk the client can afford to take) and risk required (the level of risk required to achieve the client’s goals) are all important.

    “The academic literature provides no convincing evidence for such a trait.”
    As few minutes online will uncover the large body of knowledge built over the last 60 years which demonstrates that risk tolerance is a trait, i.e. a relatively enduring way one individual differs from another. As a starting point, Google “risk tolerance Weber” and then follow the references in the paper about domain-specific risk tolerance. A smallish selection of professional journal articles can be found at our industry portal website, http://www.riskprofiling.com, under Media & Research.

    “Moreover, if the trait never changes, what can it usefully predict?”
    A robust risk tolerance test tells the adviser the level of risk the client would prefer to take – surely, a useful (critical?) piece of information. The fact that it is stable is obviously good news for advisers because this means that risk preferences do not change arbitrarily.

    “Faced with the evidence of clients’ changing tolerance of risk, …”
    The evidence is that risk tolerance does not change over time. If the results of a particular test showed changes in risk tolerance this would raise questions about the credentials of the test.

    “Why does someone who has an ATR profile of three get a cautious asset allocation? What justification is there for saying this ATR is consistent with a 30 or 40 per cent exposure to equities?”
    This is actually a good point. There does need to be a robust methodology for linking a risk tolerance score to an asset allocation. Our competitors generally do not disclose how they do this. In some cases, where there are no quantitative questions in the risk tolerance questionnaire which can be linked to the parameters of portfolio construction, it is simply not possible to do a robust linking.

    “All you can say in favour of psyquests is that they confirm what a good adviser knows as a result of knowing their client …”
    Independent studies, some of which are cited on our website, show that advisers do not have an accurate understanding of their clients’ risk tolerance. In fact, those studies show that advisers would be more accurate if they made no attempt to assess their clients’ risk tolerance and simply assumed everyone was average.

    “The best determinant of a suitable asset allocation is not attitude to risk but capacity for loss or for a shortfall from what is needed to meet a client’s goals.”
    Risk tolerance and risk capacity both act as constraints upon what a client might otherwise do. Risk capacity is an upper limit on risk whereas risk tolerance is risk comfort zone. Both are important.

  7. We consider risk to be the probability of an investment causing its owner a loss of purchasing power over the contemplated holding period. Assets can fluctuate in price and not be risky as long as they are reasonably certain to deliver increased purchasing power over their holding period. Non-fluctuating assets such as bank deposits are usually thought of as being safe, but they can be among the most risky of assets. Their short term volatility may be zero, but their long term risk is huge due to the erosive effects of inflation.

  8. The longer comment from ‘Anonymous’ 17 June 19.43 was from me Paul Resnik, Cofounder of FinaMetrica. Attribution was always intended.

  9. Adviser: Can you afford to lose this money that we’re talking about investing?

    Client: No, I need/want it to provide me with a regular income and to grow in value. If I could afford to lose it, I’d go to my local bookie and bet it on the horse I think is most likely to win the 4.30 at Kempston Park.

    Adviser: Can you afford to leave it in the building society earning 2% p.a. taxed?

    Client: No, I need a better return than that.

    Adviser: Okay. Are you prepared to tolerate a modicum of ebb and flow in the value of your investments to achieve over the long term a return better than cash or inflation, even though that cannot be guaranteed?

    Client: Yes, I could tolerate that, provided the degree of ebb and flow isn’t too severe.

    Adviser: Right, that brings us back to the Attitude to Risk questionnaire ~ agreed?

    Client: Yes, that sounds sensible.

    Adviser: And practical?

    Client: Yes, I understand what you’re saying. So where does this Capacity For Loss business fit in?

    Adviser: Search me ~ something the FSA dreamed up, but they don’t seem able (or willing) to define it in terms that any reasonable person can fathom.

    Client: Well, can we ignore it then because, like I said, my Capacity For Loss is zero but I’m prepared to accept a modicum of ebb and flow in the value of my investments with a view to achieving over the medium to long term a better return that cash or inflation?

    Adviser: Yes, I think so because, if we try to pin down just what Capacity For Loss is supposed to mean, we’ll be here all night and still no wiser at the end of it.

    Client: Right, let’s get on with it then.

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