How much of an investment risk-taker are you?
Taking a risk is key to investment returns. But how brave are you?
Proper analysis of risk can be the difference between rich and poor investors. However, the perception of risk is subjective, and the way risk is assessed is the subject of much debate.
Psychometric testing has become a popular means for advisers to achieve a better understanding of their clients' true appetite for risk. So how does it work? And is it effective?
Historically, says David Penny, managing director of IFA Invest Southwest, firms have tended to profile clients' attitude to risk by asking them where they would fit on a 'risk ladder' (with one being low risk and five being high risk); or by showing them a selection of paragraphs describing an attitude to risk and asking them to select the one that best describes them.
In both cases, it's a matter of semantics: simply finding a word or words with which the client feels comfortable, without any basis in reality. And the fact is that people are generally poor at assessing their own tolerance for risk.
Rick Eling, head of investment solutions at investment house Sanlam UK, explains: "You can't measure feelings about risk. You can't ask people what their feelings are because they won't explain in a way that readily translates into an investment profile."
Psychometric testing, in contrast, literally 'measures people's minds'. It is a means to assess their real feelings.
The three-part assessment
Eling says that there are three parts to any proper assessment of risk: tolerance, capacity and goals. Tolerance looks at how much risk an investor can live with. Capacity assesses whether an investor has the financial wherewithal to take risk. Finally, a look at goals reveals how much risk an investor needs to take.
If someone has £10,000 and only needs £10,100 in two years' time, there is little point investing in, say, emerging markets, where they might lose the lot.
Psychometric testing is used for the first part of this risk assessment: to measure people's real tolerance of risk.
Terry Thomson, chief executive of Oxford Risk, one of the main providers of psychometric tests, says: "If an adviser asks a client questions directly, he will get a considered answer. That is not necessarily how an investor feels underneath; what they feel at the core. This is why people use psychometric tests."
Indeed, says Penny, the results of the tests and the discussions around them often produce surprises. "Most commonly, a client sits down and says upfront: 'I don't want to take any risk with my money.' But a full discussion about the nature of risk, followed by the questions, will very often show them as being comfortable with short-term fluctuations, and they emerge with a moderate/balanced profile."
Psychometric tests also help to ensure that risk is assessed on a consistent basis. Thomson explains: "The basic risk categories into which psychometric testing places people don't change very much over time. However, how it expresses itself in actual decisions is a bit more dependent on what is going on in their life and the rest of the world."
For example, after a pay rise an investor may be feeling relatively buoyant about their finances.
Gemma Langlands, a financial planner at IFA Eldon, gives an example of the effect of circumstances on clients' perceptions of their own risk appetite. "Some of my clients undertook a Finametrica (another leading test provider) test in June 2008 before the credit crunch, and again in July 2009," she says.
"They expected their results to be much lower in July 2009 because of their perception of the markets and the economy at that point. In fact, the scores had only fallen around four or five points out of 100 - much less than expected."
What the test involves
So what can you expect of a psychometric test? They vary, but include a series of questions where investors are asked to judge the extent to which they agree with statements on financial decision-making (see below).
The test forms the basis of a report that can then be the starting point for a discussion about financial risk and helps the adviser to identify an appropriate asset allocation model.
Penny emphasises the importance of client education and understanding during the whole process: "Many advisers run scared of decent profiling as they feel that it will scare the client with talk of appetite for 20% losses, but in my experience clients very often go up the scale of risk after profiling because they have a far better understanding of what they are entering into."
But some advisers are cynical about the effectiveness of such profiling.
The better tests argue that they provide a consistent assessment of a person's risk tolerance, but Mark Loydall, chartered financial planner at Cambourne Financial Planning, disputes this: "Tests are influenced by circumstances and depend on where you are when you do them, what has happened in recent times and your most recent investment memory (good or bad)."
Another criticism concerns what is done with the results. The credit crisis wrong-footed many risk systems. Danny Cox, head of advice at broker Hargreaves Lansdown, points out that the credit crisis resulted in all the main asset classes falling by 40%. Few people could 'tolerate' this loss, which shows how these systems used in isolation can fail to reflect extreme events.
Psychometric testing has its limitations, but it is better than the cruder risk analysis that went before and it is becoming more sophisticated all the time. It aims to introduce some science into the art of risk profiling, but it cannot be used in isolation.
What could risk profiling reveal about you?
Below are sample questions and answers from the Finametrica risk profile. The full test involves 25 questions which are scored against the system's database and used as the basis of a detailed report, but these will give you a taste of your position on the risk spectrum.
1: Compared to others, how do you rate your willingness to take financial risks?
- Extremely low risk taker
- Very low risk taker
- Low risk taker
- Average risk taker
- High risk taker
- Very high risk taker
- Extremely high risk taker
2: When you think of the word 'risk' in a financial context, which of the following words comes to mind first?
3: Imagine you were in a job where you could choose whether to be paid salary, commission or a mix of both. Which would you pick?
- All salary
- Mainly salary
- Equal mix of salary and commission
- Mainly commission
4: Investments can go up or down in value, and experts often say you should be prepared to weather a downturn. By how much could the total value of all your investments go down before you would begin to feel uncomfortable?
- Any fall would make me feel uncomfortable
- More than 50%
5: Assume that a long-lost relative dies and leaves you a house that is in poor condition but is located in a suburb that's becoming popular. As it is, the house would probably sell for £150,000, but if you were to spend about £50,000 on renovations, the selling price would be around £300,000.
However, there is some talk of constructing a major motorway next to the house, and this would lower its value considerably. Which of the following options would you take?
- Sell it as it is
- Keep it as it is, but rent it out
- Take out a £50,000 mortgage and do the renovations.
A financial adviser who is not tied to any financial services company (such as a bank or insurance company) and is authorised by the Financial Services Authority (FSA). They can advise on financial products to suit your circumstances. All IFAs have to give consumers the choice of paying by fees or commission and have to explain which would best suit the customer in that particular instance. Also, if commission is paid either by the client or the financial service provider recommended by the IFA, the IFA must disclose what that commission is.
Generic, loosely-defined term for markets in a newly industrialised or Third World country that is in the process of moving from a closed economy to an open market economy while building accountability within the system. The World Bank recognises 28 countries as emerging markets, including Argentina, Brazil, China, Czech Republic, Egypt, India, Israel, Morocco, Russia and Venezuela. Because these countries carry additional political, economic and currency risks, investors in emerging markets should accept volatile returns. There is potential to make large profit at the risk of large losses.