Goals-based
The goals-based method is a top-down approach which attempts to identify the minimum level of risk required to ultimately achieve the returns a client desires to reach their final investment objective. However, by focusing on returns, it can avoid a conversation about an individual’s attitude to risk and is therefore arguably incomplete.
Econometric questionnaires
Econometric risk tolerance assessment methods have emerged over the last couple of decades and are based more directly on classical economic and behavioural finance theory. Econometric methods assume that a client’s position on a utility curve (and thus their risk tolerance) can be mathematically pinpointed.
Econometric methods are typically designed to deliver an ‘answer’ to the client’s risk tolerance with less emphasis on qualitative input to discuss or adjust scores. Thus, they typically arrive at a risk score without further input from the adviser or client.
Some econometric methods use games rather than question sets, which can be engaging and educational for clients. However, I would argue that results from such hypothetical scenarios do not always translate when risk becomes reality.
In my view, risk profiling should be a multi-step process in which the risk questionnaire is just the start.
As I mentioned right at the beginning, firms that assess their client’s attitude to risk via psychometrics typically use the questionnaire as discussion points to begin a conversation about risk that I believe enhances the client experience and may improve investment outcomes.
Some final considerations
How and when the psychometric questionnaire is used in the overall advice process also needs to be considered. Technology tools are still no match for a person-to-person connection that allows advisers to understand the subtle nuances about their clients.
A preferred approach, therefore, is to administer a software-based risk assessment before holding a general conversation with the client to review their answers and help them better understand the results.
Louis Williams is head of psychology and behavioural insights at Dynamic Planner
