Most people like to think they can accept a degree of risk. But perhaps some of us can take less risk than we actually think. If you want strong capital growth from your investments are you really willing to accept the degree of risk necessary to achieve the returns you want?
Consider this question: Compared to others, how do you rate your willingness to take financial risks?
•Very low risk taker
•Low risk taker
•Average risk taker
•High risk taker
•Very high risk taker
According to the Financial Services Authority (FSA) cash is a low risk asset, bonds are medium risk and UK shares are high risk. So if you're investing in shares then the regulator defines you as a high-risk taker.
But many independent financial advisers would argue that identifying your attitude to risk is not so simple. Nic Round, managing director of Murray Round Wealth Management, says: "There's a massive problem with 'Are you low medium or high risk?' People's attitudes to risk are different. I had a so-called 'medium risk' client who came to me with a bunch of property funds - that's not what I call medium risk. The definitions are not exact."
For this reason a growing band of wealth managers, along with an increasing number of professional independent financial advisers (IFAs) are using psychometric risk profiling to help determine clients' attitude to investment risk.
For example, wealth manager HFM Columbus has recently commissioned a bespoke psychometric risk profiling tool to support more traditional risk profile tools. Marcus Carlton, director of HFM Columbus, says: "Our analysis of the typical tick box questionnaires deployed by most companies investing on behalf of their clients has invariably shown the majority of clients veer towards the median.
"We believe the new psychometric profiler will help us identify carefree people and worriers, those who need more information up front and are engaged with their investments and those who are impulsive types who might make quick decisions but who may come to regret them later. It is, in short, a more scientific indicator of risk appetite."
Personality profilers are widely used by human resources teams at recruitment stage but are thought to be less common when deployed in understanding private investors' attitudes to risk.
Psychometric profiling typically embraces five major personality traits:
Openness - appreciation for art/emotion/adventure, unusual ideas, curiosity, and variety of experience
Conscientiousness - a tendency to show self-discipline, act dutifully and aim for achievement; planned rather than spontaneous behaviour
Extraversion - energy, positive emotions, urgency and the tendency to seek stimulation and the company of others
Agreeableness - a tendency to be compassionate and cooperative rather than suspicious and antagonistic towards others
Emotional stability - a tendency to experience unpleasant emotions easily, such as anger, anxiety, depression or vulnerability.
Mr Carlton explains: "We anticipate that the client's degree of conscientiousness will inform us if they are rash decision makers or if they make more studied decisions, and the profiler will also look at emotional stability in order to analyse likely reaction to unexpected outcomes - for example severe market volatility - so that we can protect clients and manage their expectations better."
Psychometric testing is not only in the interests of the investor. It also helps protect the adviser, creating a much clearer paper trail to go with every recommendation, making it harder for clients to be mis-sold a product, and harder for them to make a claim for mis-selling or bad advice.
Mr Round says: "If there was a perfect answer it's a portfolio matched to a psychometric test." But as yet, this doesn't exist. And psychometric testing in itself is not exact. "The problem is you can ask different people at different times and get different answers," he says.
Nevertheless, by including elements of psychometric testing to determine risk appetite, these advisers are making a serious point about how understanding your personality and behaviour can impact on investment decisions. In any event, your risk tolerance should be re-tested every two or three years as it usually does change (slowly) with age.
Investors without the required wealth or inclination to use the services of an expensive wealth manager can do their own risk tolerance questionnaire at www.myrisktolerance.com for £16.
FOUR RISK TOLERANCE QUESTIONS
Smart - and happy - investors know their risk comfort zone and make money in ways they feel at ease with. Here are some questions from Murray Round Wealth Management to help you determine how much risk you can handle.
1. Your investment loses 15 per cent of its value in a market correction a month after you buy it. Assuming that none of the fundamentals have changed do you:
a. Sit tight and wait for it to journey back up?
b. Sell it and rid yourself of further sleepless nights if it continues to decline?
c. Buy more - if it looked good at the original price it looks even better now?
2. Which would you have rather done?
a. Invested in an aggressive growth fund which appreciated very little in six months
b. Invested in a money-market fund only to see the aggressive growth fund you were thinking about double in value in six months?
3. Would you feel better if?
a.You doubled your money in an equity investment?
b.Your money-market fund saved you from losing half your money in a market slide?
4. It's 1992, and inflation is returning. Hard assets such as precious metals, collectibles, and real estate are expected to keep pace with inflation. Your assets are now all in long-term bonds. What would you do?
a. Hold the bonds?
b. Sell the bonds, and put half the proceeds into money funds and the other half into hard assets
c. Sell the bonds and put the total proceeds into hard assets?
d. Sell the bonds, put all the money into hard assets, and borrow additional money to buy more?
