Louis Williams – Head of Psychology & Behavioural Insights at Dynamic Planner – analyses the risk profiling process, from start to finish, for your clients. He considers: why are risk profiling questionnaires psychometric? What does psychometric mean?

What are the alternatives for financial advice firms? What are the pitfalls to avoid? And how did Dynamic Planner and Henley Business School successfully navigate those dangers when they created their attitude to risk questionnaire? You can also view our recorded webinar where Louis discusses this, “Why use psychometric risk profiling anyway?” here.

Why do financial advice firms risk profile clients?

First, FCA rules state that firms must and are obliged to understand more about their clients’ investment objectives and risk tolerance, so that they can make them the most suitable recommendations, based on that understanding.

This understanding enables advisers to help the client achieve their objectives and, vice-versa, it helps the client understand the financial planning and advice process more clearly and brings them more into that process. That, in turn, deepens the relationship between the adviser and the client and facilitates fruitful conversations here.

How do advice firms risk profile clients?

The most common approach currently is by a risk questionnaire and ultimately matching clients with investments based upon an agreed risk profile. Clients complete questionnaires, each answer within the questionnaire is scored and those scores are aggregated, resulting in a final score from one to 10, for example, where one represents the lowest level for risk tolerance and 10 the highest level.

Why are risk questionnaires psychometric? And what does psychometric mean?

It is easy to think it is simply about the end product, so to speak, and the measurement of someone’s personality or attitude. But psychometric is also about the process of creating a tool to measure someone in this way. How does the tool interpret and achieve that final measure? Psychometrics therefore are about understanding the tool itself and testing if it is valid and reliable.

Attitude to risk is often stated as a psychological trait, but I would argue it is more complex than that.

If the former were true, our attitude to risk would be identical in different scenarios – for example, by taking a ride on a rollercoaster. But in that example I know my attitude to risk is very different compared to my attitude to risk concerning my finances. Therefore, attitude to risk is not that simple and as a result, we need to ensure that we create a tool for measuring what we want it to measure: specifically, someone’s attitude to risk concerning their pensions and investments.

Are there alternatives to risk questionnaires?

There are other methods which purport to be more objective than risk questionnaires, because, for example, they are founded on measuring someone’s experience or past behaviour in this context. But that doesn’t necessarily mean they are more valid.

One alternative is the Multiple Price List method, where clients are given choices and they make decisions until a tipping point is reached regarding their risk tolerance.

This method can be problematic because of something called extreme aversion bias, where the client continually opts for the safe, middle option. One example here might be going to the cinema and choosing a regular bucket of popcorn, avoiding choosing the small or large bucket. In that way, the client here is not fully considering the consequences of their choices. It could also be argued that the Multiple Price List method does not measure a client’s capacity for risk.

Are there other alternatives to consider?

Yes. One is a financial anamnesis, similar to how a doctor would look at a patient’s background and family history to discover more about them. But of course, this method can be unreliable when the aim is to understand more about the individual client, not their family or any stereotypes.

We can, of course, look at the individual’s investment experience, and Dynamic Planner’s risk questionnaires do consider this as part of a complete, holistic approach. On its own, though, this has problems, because what if the individual has never invested before?

A final alternative we can consider for the moment is a goals-based method – a top-down approach which looks at the risk required to ultimately achieve the returns a client desires to reach their final investment objective. But this avoids a conversation about an individual’s attitude to risk and is again arguably incomplete.

Do psychometric questionnaires have limitations?

In short, yes. A client’s answers can be flawed, but that then can fall back to the adviser to ensure that the client is fully engaged with and fully understands the process and questions.

On another side of the coin, we can acknowledge that the tool itself we are using has flaws, which is what happened in 2017 when Dynamic Planner first partnered with the University of Reading and Henley Business School to create a new and better tool here – a tool which was not only arguably better, but had purpose, as we have seen, behind the design.

What are the potential pitfalls to using a psychometric questionnaire?

  • A questionnaire might not have been built with psychometric testing theory
  • The terminology in questions might be very complex – or assume prior investment or mathematical knowledge
  • Questions might overlap and repeat themselves in some way, which can be frustrating for the respondent and invite problems, because the client naturally answers differently, assuming each question aims to elicit a fresh response
  • Finally, a question set might not capture and measure multiple dimensions of risk and ignore, in particular, the importance of emotions here. How does someone feel about risk?

How can you combat any questionnaire flaws?

First, we need to think about the questions themselves and how they are constructed. Are they open or closed questions, for example? Further, what does each question measure and how do we measure someone’s response? What different options or rankings do we give an individual for their response?

We also need to think about the number of questions we include and reach a balance, between a suitably holistic understanding of a client’s complete attitude and emotions, but avoiding fatigue setting in when someone is completing the questionnaire.

Furthermore, what is arguably vital is striking a balance between using the same response options for questions and the direction of phrasing in each question.

It is usual to have responses ranging from ‘strongly agree’ to ‘strongly disagree’ throughout. However, are questions phrased in different directions, so it effectively engages the client and avoids encouraging an individual to disengage and click ‘strongly agree’ each time?

The questions themselves must be direct and tailored to measure someone’s risk tolerance regarding their finances. However, we need to be careful that they are not so specific that they question the individual about actual investment choices, like the Multiple Price List method. Therefore, we need to avoid hypothetical questions, any ambiguity and also double-barrelled questions, which demand the client tries to answer two questions in one, which of course could prove very problematic.

Once we have our final set of questions, we of course have to test it, which was something Henley Business School and Dynamic Planner realised was vital when they designed their risk questionnaire in 2017 before its launch in early 2018.

To test it, we can use pilot studies and / or focus groups to discover potential flaws in the questions; examine their validity; and also consider any ethical issues perhaps not previously considered.

We can also test engagement here. How long does it typically take a respondent to complete the questionnaire? Are they just ‘straight lining’ and clicking the middle option, as we have seen, for each answer? We can also gauge if questions are eliciting an appropriate range of responses – and if people understand questions and are therefore answering them how we would want.

After initial testing, it is then possible to compile all your pilot data and run analyses to highlight if any questions are effectively redundant or if there are inconsistencies in what we, holistically, are asking respondents. Does that make our question set weaker, as a whole?

How did Dynamic Planner and Henley Business School create its risk questionnaire in 2017?

First, as we have seen, they asked, ‘What are we measuring here?’ Answer: attitude to risk, which they broke down into three elements based on academic theory – attitude to risk concerning financial gains which can be made, concerning losses and concerning the context in which a decision is made. How do those different components frame someone’s attitude to risk?

They therefore considered what are termed drivers, constrainers and enablers in relation to an individual’s motivation to either take risk or feel inhibited when taking risk.

Henley Business School and Dynamic Planner also considered different types of attitude structures and how an individual adopts them to evaluate a product or a concept. What are attitudes based on – logic, emotions or on observations or interactions they have experienced?

The final questionnaire created in 2017 encompasses all these multiple dimensions regarding an individual’s attitude to risk. It was then robustly tested using a large population set. Focus groups were also used to help test what advice firms and their clients see when they begin the risk profiling process in Dynamic Planner today.

Hear more from Louis Williams, Head of Psychology & Behavioural Insights, in this webinar recording: “why use psychometric risk profiling anyway”.

If you are not already a Dynamic Planner user – and would like to find out more about how we can help you and your firm – please get in touch.