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A new way of assessing attitudes to risk
Posted by Chris Budd Tuesday, April 11, 2017
For many years now we at Ovation have been uncomfortable with traditional ways of assessing a person’s attitude to risk.
Some of the deficiencies were obvious to us. One example is the use of set questions such as ‘How would you feel if markets went down by 20%’. These can be pretty blunt questions. How would I feel? Terrible, how do you think I would feel?!?
Due to this we’ve always believed that such questions should only ever be the starting point of a conversation. But if we are assessing risk by way of discussion, how can this be recorded? How can it be consistent? And how can we translate this into investment portfolio construction?
Some of the drawbacks of such an approach were more subtle. We’ve been learning more about these from Neil Bage of a company called Suitable Strategies who are using surveys and new academic research to change risk .
For example, there is ‘Framing’. It seems that if you ask someone a question in a certain context, it will influence their response. So, if you ask someone about risk when sat in a financial adviser’s office, they will relate the question to money.
Let us take an example. Susie is a 17 year old young lady who lives with her parents. She’s been invited to a party, but she knows her father doesn’t approve of the young man in question. Furthermore, she’d really like to stay out until midnight for the first time ever, and needs a lift home.
Susie says to her father “Dad, I’m going out to a party on Saturday night.”
“Really?” replies her father. “And whose party is this then?”
“Oh, a friend. I’ll be back around 2 a.m., ok?”
“Two a.m.?!” splutters her father. “You will not, my girl. You will be back by midnight. And what’s more I will be waiting for you in the car to make sure of it!”
Susie frames the issue around the lateness of her return, and in doing so avoids the subject of whose party it is, gets to stay out as late as she wanted to, AND has a lift home!
Now, it seems that people with low numeracy skills are particularly susceptible to framing. But then, who has low numeracy skills? Most of us, as it turns out! Two thirds of the UK population are assessed to have low numeracy skills. And this is NOT linked to academic achievement.
So, most of us are not great with numbers and are influenced by the context in which a question is asked.
When we apply these ideas to understanding a person’s attitude to investment risk, we can start to see some of the problems with the current approach. Discussions about money tend to be framed around investment percentages, asset allocations, and annual returns.
Perception and reality
Neil’s company have created a way of measuring risk which is based on our actual behaviour, rather than what we think our behaviour might be. This is partly because research shows that as we gain knowledge, our self perceived skill levels grow quicker than our actual knowledge.
So as we learn a bit about, say, how investment markets work, we think we’ve got it all nailed before we actually do. One interesting outcome is that people’s perceived attitude to risk tends to be higher than their real attitude to risk. In other words, how they think they would react is often very different to how they actually react.
The profiling tool Neil’s company has developed is very careful to avoid telling people they might be wrong about themselves – we don’t tend to readily accept such criticism! But discussing how to apply the results of such a test to a person’s financial plans, to their lives even, needs tact and skill. The sort of skills our advisers learn as financial coaches.
At Ovation we adopt a process of financial coaching first, financial planning second, and financial advice (products) third. We help people work out what they want from life, create a plan to get there, then use our technical knowledge to make it happen.
This new approach to assessing attitudes to risk is therefore ideal for us, as it will provoke meaningful discussions. Our clients end up with financial plans which truly provide a clear path to identifiable objectives.
We are very much looking forward to rolling out the new profiling tool, and are sure our clients will find the results as interesting as we do.