Could psychometric tests help your investments?
The traditional approach for advisers and wealth managers looking to get a handle on their clients' attitude to risk and return has been to use a risk-profile questionnaire.
That involves clients answering multiple-choice questions such as: "if your portfolio fell by 20%, would you sell up or buy more?" or "how would you describe your level of investment knowledge and experience?"
But Marcus Carlton, director of wealth management company HFM Columbus, believes that while risk profiles help to point advisers in the right direction as far as client preference is concerned, they can be two-dimensional tools because clients don't necessarily assess their own personalities accurately.
"We have been using conventional risk profiles based on self-assessment for about 20 years," he says. "Most people fall somewhere in the middle range, as relatively medium-risk investors, but that doesn't necessarily tell us how they will react to specific circumstances.
For example, we had two medium-risk clients holding the same asset, which lost about 25% in value. One saw it as a great opportunity to buy more; the other panicked and wanted out altogether."
Carlton is one of a growing number of advisers beginning to make use of psychometric tests - more familiar to HR professionals as a recruitment tool - for clients interested in probing their subconscious with regard to financial decisions and their capacity to manage risk.
Other firms that have introduced the test include Barclays Wealth, Cotswolds-based Broadway Financial Planning and Fortitude Financial Planning in Northamptonshire; the latter two making use of the Finametrica risk-profiling tool.
Psychometric tests aim to explore the key personality traits likely to shape a client's responses.
In the context of financial planning, these traits include emotional stability (which could affect reactions to market volatility); openness (influencing level of interest in new investment ideas); conscientiousness (shaping the tendency to be self-disciplined or act rashly); and compliance (which influences willingness to follow rules and take advice).
The Risk Compass test used by HFM Columbus comprises quick-fire responses to 142 brief statements that, surprisingly, can be completed in about five minutes.
Typical examples include: "I dare not hope for the best", "I don't hold grudges", and "Most people have some positive qualities".
The results are plotted as a single marker on a target divided into eight equal segments, each labelled with a personality trait: wary, prudent, deliberate, composed, adventurous, carefree, impetuous and impassioned.
So most people, unless their marker falls on a boundary, are defined by a single category, but positioning within the segment is important.
Therefore, when the marker is near the outside edge of the target, clients are likely to relate more strongly to that characteristic, and conversely when the marker is near the middle they are likely to be less powerfully influenced.
When it's close to an edge aspects of the neighbouring characteristic may also resonate.
What kind of impact may such a test have on client portfolios? To answer that question, we looked at two clients of HFM to see how the test results differed from their existing risk profile and how that might shape the adviser's future recommendations for their portfolio.
Case study one
Photographer Barry Herman is an interesting case. He spends his spare time riding powerful motorbikes, so is no stranger to the idea of an edgy existence.
But as Carlton points out, familiarity with and understanding of the risks involved in an experience tends to lessen our fear of it - a lesson that applies to investing just as it does to bike-riding.
Herman's attitude to investment is relatively cautious, according to the conventional risk profile. He came to HFM as he was dissatisfied with the poor performance of his portfolio of pensions with Aviva and Standard Life.
He wanted greater diversification to avoid the large fluctuations he had suffered from one valuation to the next, plus downside protection.
James Tuson, an investment manager at HFM, explains: "Our analysis was that high charges contributed to the poor performance of the pensions, so we shifted them to a lower-charging Sipp, where we could also use a wider range of assets."
Within the SIPP, HFM built a lower-risk portfolio, using around 40% structured notes to manage the downside risk and capture some potential upside from various markets.
It also contained a mix of property funds for income flow and to reduce correlation, absolute return funds for steady growth and low volatility, and corporate bond funds for further diversification and income.
That strategy worked for Herman, but when he took the psychometric test, he emerged as an absolutely balanced investor with his marker bang in the centre of the target, indicating that he is not as cautious as he perceives himself to be.
"The results suggested that his earlier answers to our standard risk assessment were actually driven more by his past disappointment over the performance of his pensions than by his real capacity to accept investment risk," observes Tuson.
As a consequence, he adds, the portfolio could be realigned towards more adventurous products.
"We'll be talking to him about the possibility of incorporating small positions in equity funds, focusing on blue chip funds and equity income as an entry point, and using cash released as the structured products mature."
Case study two
The second case study also demonstrates a mismatch between the risk-profiling exercise and the psychometric test. Simon Jeffries is an investment professional, so is familiar with conventional and more esoteric investments.
Therefore it was not surprising when he registered on the risk profile as comfortable with a higher-than-average level of risk for his pension portfolio. That outlook was reflected in its core/satellite make-up, explains Tuson, and it has worked well for him.
"As well as building a core advisory portfolio containing a range of fixed interest, equity and property funds, plus some individual equities, which raise its risk profile, he also invested in more esoteric assets such as commercial property syndicates and enterprise investment schemes," Tuson says.
But the psychometric results suggest Jeffries's work may boost his confidence and encourage him to overstate his risk profile, which would otherwise be more medium-risk.
His marker sits clearly in the impetuous sector and towards the impassioned border, but it's not far from the balanced centre.
The main concern for impetuous types, as raised by the psychometric test, is that although they embrace risk and are likely to be open-minded about new opportunities, they worry about their financial affairs and may also feel resentful if things don't go according to plan.
"The analysis of Simon's test indicates that he makes fast decisions and likes to resolve outstanding issues quickly, that he is passionate about things generally, that he can be a worrier, but he has an analytical approach and feels it is important to base decisions on facts and logic rather than emotion," explains Carlton.
While not wishing to dampen Jeffries's enthusiasm or readiness to experiment, Tuson is keen that he should consider introducing a less volatile element to his core portfolio.
This might be achieved by incorporating assets less correlated with commercial property, perhaps using funds or equities in blue-chip companies particularly in defensive sectors such as pharmaceuticals or household goods.
Moreover, Tuson stresses that HFM Columbus will henceforth be "very pedantic" when it comes to highlighting the risks of any new investment opportunities that come Jeffries's way.
Clearly, in addition to providing the client with food for thought, the findings of psychometric tests can also help to define the financial adviser's role in the investment process.
However, it's important to understand that these findings are not set in stone. Instead, they provide a starting point for discussion with the client.
"Clients might disagree with the analysis, but we hope it gives us a better insight into their financial requirements and how we should manage their needs and expectations," comments Carlton.
This article was originally published in Money Observer - Moneywise's sister publication - in March 2010
Structured products offer returns based on the performance of underlying investments. Many products are linked to a stockmarket index such as the FTSE 100 or a “basket” of shares. There are generally two types of product, one offers income, the other growth and investors have to commit their capital for the prescribed term, usually three or five years. The investment is not guaranteed and if the index or basket of shares does not perform as expected over the term the investor might not get back all their capital.
A catch-all phrase that can range from assessing the price of a property or vehicle before offering it for sale or the net worth of assets in an investment portfolio to the prices of shares on a stock exchange.
Like a self-select ISA but for pensions, self-invested personal pension is a registered pension plan that gives you a flexible and tax-efficient method of preparing for your retirement. It gives you all sorts of options on how you put money in, how you invest it and how it’s paid out and offers a greater number of investment opportunities than if the fund was managed by a pension company. SIPPs are very flexible and allow investments such as quoted and unquoted shares, investment funds, cash deposits, commercial property and intangible property (i.e. copyrights, royalties, patents or carbon offsets). Not permitted are loans to members or people or companies connected to the SIPP holder, tangible moveable property (with the exception of tradable gold) and residential property.
Corporate bonds are one of the main ways companies can raise money (the other is by issuing shares) by borrowing from the markets at a fixed rate of interest (the reason why they are also known as “fixed-interest securities”), which is called the “coupon”, paid twice yearly. But the nominal value of the bond – usually £100 – can fluctuate depending on the fortunes of the company and also the economy. However it will repay the original amount on maturity.
Named after a high value gambling chip, the term is used for an investment seen as solid and whose share price is not volatile. Blue chip companies are normally household names and have consistent records of growth, dividend payments, stable management and substantial assets and are the bedrock of a pension fund’s portfolio.
Absolute return funds
Absolute return funds aim to deliver a positive (or ‘absolute’) return every year regardless of what happens in the stockmarket. Unlike traditional funds, they can take bets on shares falling, as well as rising. This is not to say they can’t fall in value; they do. However, over the years, they should have less volatile performance than traditional funds.
An interchangeable term for shares (UK) or stocks (US). Holders of equity shares in a company are entitled to the earnings and assets of a company after all the prior charges and demands on the company’s capital (chiefly its debts and liabilities) have been settled. To have equity in any asset is to own a piece of it, so holders of shares in a company effectively own a piece proportionate to the number of shares they hold. (See also Shares).