Risk Tolerance Assessment

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Risk Tolerance Assessment

• Geoff DaveyCo-Founder and CEOFinaMetrica Pty
  Limited
• David Cordell, PhD,CFA,CFPAssociate Professor
  Personal Financial PlanningTexas Tech
  University

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The Meaning ofRisk Profile/Profiling

• An assessment of an individuals risk tolerance.
• or
• An assessment of the risk(/return) in an
  investment strategy (thought to meet the clients
  needs.)

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Whatisrisktolerance?
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Psychological Trait

• A relatively enduring way one individual differs
  from another.

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Financial Risk Tolerance

• The extent to which an individual would normally
  choose to risk experiencing a less favourable
  outcome in the pursuit of a more favourable
  outcome.
• ISO Draft Standards

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• Risk ToleranceHow much risk I choose to take.(a
  psychological construct)
• Risk CapacityHow much risk I can afford to
  take.(a financial construct)

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Whats yourrisk tolerance?
Uh?
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Assessment Techniques

• Interview-based(subjective clinical judgements)
• versus
• Test-based(psychometric instrument)

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Adviser Anomalies

• Different advisers have different interpretations
  of same statement.
• Gender stereo-typing
• Males ? Females ?
• Client self-estimates more accurate than adviser
  self-estimates and adviser-estimates of clients.
• Advisers use flawed heuristics.

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Psychometrics

• Psychology and statistics
• Science of test construction
• Standards for evaluating tests
• Validity, reliability and accuracy

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Test Development
Pool of Questions
Sample Questionnaire

• Useability Trials
• Understand?
• Answer?

Norming Trials

• Statistical Analysis
• Validity?
• Reliability?
• Accuracy?

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PsychometricRisk Tolerance Test
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(No Transcript)
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(No Transcript)
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Risk Profile Report
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Industry-Standard Questionnaires

• In theory,should not work.
• In practice,do not work.

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Insights from Psychology and Psychometrics on
Measuring Risk ToleranceJournal of Financial
Planning, April 2005
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Industry-Standard Questionnaires

• Too many bad questions.
• Too few good questions.

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Reliability

• Test Score True Score Error
• Reliability (r) Correlation between Test Score
  and True Score
• Error (SEm) StdDev x ?(1-r)
• Reliability (r) f(no of questions2)

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Risk Tolerance Characteristics

• 4 types physical, ethical, social and financial
• Normally distributed
• No sub-factors
• Males gt females by 1 sd
• Negative correlation with age, marital status and
  dependants
• Positive correlation with income, assets and
  education
• Advisers gt clients by 1 sd
• Clients estimates correlate .68
• Advisers estimates correlate .38

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Standard Methods
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• An individuals behaviour in a risky situation
  will be a function of goals, risk tolerance,
  (perceived) alternatives, (perceived) level of
  risk, etc.

Behaviour f (Goals, Risk Tolerance, Risk, etc.
)
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Risk tolerance is relatively stable but
perceptions of risk can change in an instant!
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1999 2002 Quarter-By-Quarter Risk Tolerance
Scores
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Know The Client

• Must Do
• Should Do
• Could Do

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The FinaMetrica System

• Scientific assessment of personal financial risk
  tolerance.
• A robust methodology for incorporating
  assessments into the planning process.
• Unique educational materials to explain portfolio
  risk in the context of the clients risk
  tolerance.

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www.risk-profiling.comEducators and Researchers

• Free use of the FinaMetrica system and associated
  intellectual property.
• Access to our database of completed risk
  profiles.
• Assistance with preparation of course materials.