With stories of unsuitable investments hitting the headlines again, the grounds for recommending one investment over another need closer scrutiny. That risk-tolerance tests are an essential piece of this puzzle is already acknowledged. That these tests are often unfit for purpose is, sadly, not.
Measuring risk tolerance well is mostly about avoiding common mistakes. Be it measuring something other than risk tolerance, confusing the audience, or relying on guesswork or substandard psychometric science, most attempts to measure risk tolerance fail in at least one crucial way.
How not to measure risk tolerance
Although the need to access investors’ risk tolerance has been embedded in law for a long time, the means of doing so have failed to meet what should be non-negotiable scientific standards. Items that pass the audition for inclusion in an assessment should be simple, but the process by which they are chosen shouldn’t be. Too often, assessment-designers get this the wrong way around: combining overly complex statements with too little statistical rigour.
Many understand the necessity of psychometric tests: we know that investors can’t reliably isolate the factors that affect how they think about risk at any one time. However, few grasp the concept that not all psychometric tests are created equal. Poor design can drive a distorting wedge between what a test means to ask and what it actually does, resulting in unsuitable outcomes. For example, you may aim at "How much risk are you willing to trade-off for better returns in the long-term?", but end up hitting: "How do I feel about taking investment risk this morning?".
Getting risk tolerance right is a science. Getting it wrong is a serious - and potentially costly - error.
Top tips on how not to do it:
The ideal solution dodges these traps and the risk of unwittingly failing the investor in the process. If a job’s worth doing, it’s worth doing well.
Greg B Davies, PhD - Head of Behavioural Science, Oxford Risk
Greg is a specialist in applied behavioural finance, decision science, impact investing, and financial wellbeing.
He started the banking world’s first behavioural finance team at Barclays in 2006, which he led for a decade.
In 2017 he joined Oxford Risk to lead the development of behavioural decision support software to help people make the best possible financial decisions.
Greg holds a PhD in Behavioural Decision Theory from Cambridge; has held academic affiliations at UCL, Imperial College, and Oxford; and is author of Behavioural Investment Management.
Greg is also Chair of Sound and Music, the UK’s national charity for new music, and the creator of Open Outcry, a ‘reality opera’ premiered in London in 2012, creating live performance from a functioning trading floor.
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