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Paul Resnik: Why psychometrics have a place in financial planning

Paul responds to a recent piece from Money Marketing columnist Chris Gilchrist calling for psychometric questionnaires to be scrapped.

Paul Resnik FinaMetrica Grey

The preferred outcome of the advisory process is that the investment recommended suits the investor’s goals and also takes into account the investor’s risk capacity and risk tolerance.

This process is a blend of art and science. The science lies in the tools the adviser uses. The art lies in the adviser’s ability to use the tools effectively, to work collaboratively with clients to understand their needs, to assist in resolving mismatches by explaining alternatives, and to guide the decision-making process.

When assessing risk acquired, the projection capabilities of good planning software are used to determine the return required to achieve goals. There will be a level of risk associated with that return – and this is the risk required. The portfolio selection is based on this.

The science lies in the financial planning software. The art lies in explaining the relevant issues to the client, eliciting the right information, resolving conflicts, and determining expected returns for portfolios and the capital market assumptions upon which they are based.

Risk capacity is the extent to which an individual’s financial plan can withstand the impact of unexpected events.

For a goal as important as income in retirement, for instance, a 50 per cent chance of success is unlikely to be acceptable, which means that trade-offs will be required. In a comprehensive scenario, risk capacity is measured by the excess over 50 per cent of the likelihood of achieving goals.

Clearly, unexpected negative outcomes might derail the client’s plan and this means the plan must be stress-tested. All forms of stress testing are driven by assumptions: capital market assumptions for investment returns, life expectancy for longevity and so on. If we do a poor job on these assumptions, any stress test will be compromised.

With risk capacity, the science is in the calculations, the art lies in explaining the concept to the client.

Risk tolerance is how an individual feels about taking risk. Where is their emotional balance between a favourable outcome versus risking an unfavourable outcome?

Psychometrics is the scientific discipline used to assess characteristics such as risk tolerance. With risk tolerance, the science is in the questionnaire and scoring algorithms.

The art is in the discussion between adviser and client – explaining the risk tolerance report, resolving inconsistencies, arriving at a final assessment, obtaining acceptance of the assessment.

Risk tolerance is more likely to be consistent between planning sessions than risk required and risk capacity. That consistency makes it a useful foundation for both planning and investment decisions.

Paul Resnik is a director at FinaMetrica


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There is one comment at the moment, we would love to hear your opinion too.

  1. This explains the importance of using planning software to assess what return is required, and to explore the risk associated with a portfolio that could achieve this return. Great.

    But what use is it to measure the individual’s feelings on how much risk he could tolerate?

    Let’s say his risk tolerance is ‘high’. Does that mean he should accept a 60% chance of missing the goal? Or 50% 30%?

    Surely it’s better to be less ambiguous with the client and simply ask him what confidence he requires for that goal. E.g. I require a 90% chance of hitting that goal. The portfolio can then be designed accordingly.

    Otherwise different circumstances (wealth versus goal size) could produce radically different likelihood outcomes for people with the same ‘feelings’.

    In many cases feelings aren’t relevant – if the person just doesn’t have enough money to aim for that goal then they should be told that, rather than encouraged to gamble.

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