Risk tolerance profiling
Assessing investors’ risk tolerance – their willingness to take risk – is at the heart of suitability.
What is risk tolerance profiling?
Risk tolerance is a psychological trait that reflects an investor’s stable, long-term willingness to trade off risk for return and should not be conflated with short-term behavioural traits. A risk assessment that confuses these will give too much weight to temporary emotional responses, with costly consequences.
How should it be measured?
The Oxford Risk approach is based on three core principles of what risk tolerance is:
A psychological trait: risk tolerance, like other traits, is stable over time and is best measured by a psychometric questionnaire.
Independent of short-term behavioural tendencies: assessments should be outcome-oriented and should not be distorted by journey-oriented measures (such as composure).
Sensitive to subtleties in question interpretation: questions should be selected on the basis of thorough and statistically rigorous testing.
Using these principles as the basis of a risk tolerance assessment helps improve investors’ financial decisions. It can only be achieved with a level of statistical rigour and behavioural-science expertise that Oxford Risk is uniquely able to provide.
The only proven methodology to assess risk tolerance accurately is via psychometrics. Avoid tests using any other process, especially “revealed preferences”. They don’t work.
How can a good risk tolerance assessment help advisers and investors?
Suitability may be undermined if investors’ portfolios are built solely on the basis of their risk tolerance, without taking other aspects account. The risk tolerance assessment should therefore be part of a wider process of investor understanding and engagement, rather than a standalone box-ticking exercise.
The assessment process can help investors build a better understanding of their investment personality, and of the role that investments can play for them. That can in turn promote greater engagement with the processes of assessment, advice, and portfolio construction.
How does Oxford Risk assess risk tolerance?
Avoid using “quick fix” solutions from providers who have sprung up in recent years to cash-in on fear – they often purport to have processes and services “backed by” Nobel-Prize-winning theories. They don’t. The Oxford Risk approach to risk tolerance is designed to overcome common flaws that undermine many risk tolerance tools (such as conflating long-term traits with short-term behaviours, including questions that are confusing for investors, or using gamble choice tools that do not lead to stable results), and ensure that:
The assessment is valid and reliable – it measures what it sets out to measure and offers a fair representation of the investor being assessed.
The assessment helps to streamline adviser processes and provide control over investor information.
The assessment is part of a wider set of insights into investment suitability – it is as ongoing and dynamic as the investment journey itself.
The only proven methodology to assess risk tolerance accurately is via psychometrics.