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In the previous article of this series (Click Here), we discussed how you can sharpen your risk profiler from a conventional uni-dimensional questionnaire to a three dimensional one, to help you understand your clients better, and thus advise them more appropriately. Taking the 3-D risk profiler a step forward, we now discuss the latest cutting edge tools that are being used in this space: psychometric tests to understand your client's psychology and attitude towards risk and money.
What is a psychometric test?
Psychometric tests are developed on scientific methods in social sciences field and used to measure individuals' mental capabilities and behavioural style. Based on the answers, psychometric tests can be used to help to identify a person's skills, knowledge and personality. A psychometric test is a questionnaire that requires honesty from the user. There are two main types of psychometric tests - personality tests and aptitude tests.
Personality tests are sometimes used as a screening process to vet potential employees to see if they would be a right fit with the company culture. The tests can reveal interests, values and motivations as well as emotions, behaviours in a variety of situations and these are used to judge if a candidate is a right fit.
Aptitude tests assess cognitive or reasoning ability and can indicate if the candidate has the right skill set for a job role. These tests are often used by career counselors to help students looking to figure out where their interests and aptitude lie and choose an appropriate degree.
Psychometric tests in the financial space
Psychometric tests have now evolved to other spheres including understanding a client's risk profile. In the previous article, the three dimensional approach to risk profiling was explored to understand the client's risk profile is made of risk capacity, return required and risk appetite. Return required is the risk-return of the portfolio the client is looking for in order to achieve their goals. Financial ability, also known as risk capacity, is the extent to which the client is financially able to accept a short-term capital loss in order to gain a more favorable outcome later.
Risk attitude, also known as risk tolerance or risk appetite, is the psychological willingness to take risk. Risk attitude relates to the psychology of the client and it is not based on financial circumstances. Some individuals are naturally inclined towards taking risks while others are naturally more cautious. This often has nothing to do with investments - its just the way they are. Finding out how much of a natural risk taker your client really is, will help you immensely in guiding him towards an appropriate asset allocation.
Conventional risk profiling questions typically focus on investments. The problem with this is that the answers get hugely biased by the individual's current frame of mind towards markets. If he is very bullish about market prospects, he will readily answer questions on volatility that suggest that he has significant risk appetite - and vice versa. In order to understand his real risk appetite, you need to understand his risk taking capacity outside the world of markets and investments - and then extrapolate that into his portfolio. That's where psychometric tests help in a big way.
Sample questions
These are a few examples of questions that a psychometric testing based investor profiler would ask:
Q1. Two weeks before you are about to leave on your dream holiday abroad, you lose your job. What will you do?
Cancel the trip Take a trip to a nearby hill station or a beach location within India Go as scheduled because you need a break from the stress Enjoy the vacation and do all that you wanted and more because you may not get a chance like this again.
Q2. You are on a TV game show and can choose one of the following. What will you choose?
Rs. 1000 in cash a 50% chance at winning Rs. 5000 a 25% chance at winning Rs. 10,000 a 5% chance at winning Rs. 50,000
Q3. How would your best friend describe you?
A real gambler Willing to take risks only after you gather facts and have time to understand Cautious Avoids risk at all cost
Q4. When you think of the word "risk" which of the following words comes to mind first?
Loss Uncertainty Opportunity Thrill
Q5. Your trusted friend is opening a new business venture. If successful, the venture would return 30 to 50 times the investment. Given the economy, your friend estimates the chance of success at 25%. How much would you invest?
Nothing One month salary Three months salary Six months salary
As can be seen, none of these questions directly relate to an individual as an investor or his attitudes towards an investment portfolio - but they do give you a good understanding of how much of a risk taker the individual is.
Access the latest diagnostic aids - at a subsidized cost
FinaMetrica is one of the global leaders in the field of psychometric testing based investor profiling. Other prominent palyers include VisualDNA and Entrepreneurial Finance Labs (EFL).
DSP Blackrock has tied up with FinaMetrica to offer Indian IFAs a chance to try out this cutting edge advisory support tool, and if convinced, to buy it at a highly subsidized rate.
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While most psychometric tests are a straight questionnaire, some are stepping away in newer directions to test the risk attitude of clients. VisualDNA uses an online photo quiz that asks respondents to choose a photo from a selection in response to a question like "how do you respond to bad news?" Clients would choose one of the photos - a pressure cooker, a rope about to snap, a rubrics cube and a maze - to answer the question.
Does it actually work?
There are critics who question the reliability and usefulness of psychometric testing in financial advising. Psychometric tests are limited by a person's ability to interpret the results and so it raises questions on whether it is easy to underestimate or overestimate the true risk tolerance of the client given the complexity of human behaviour.
Most people like to present a certain image of themselves and so they may not be honest while answering the questions. People also do not always understand themselves as well as they think and this could also colour their responses. Since the responses are emotionally driven, the results may be a reflection of what is going on in their lives, their recent investment memory and their circumstances and not the personality of the client and their ability to handle risk. Even if the tests work, some advisors still feel that the results may not accurately reflect clients' behaviour in extreme events in the markets which is hard to predict.
To conclude
Doctors use a range of techniques to diagnose a patient's ailments. Some ailments are detected by simple physical examinations, some require blood tests, some require X-rays and others require more sophisticated examinations like MRIs and CAT scans. A good doctor is one who is familiar with all types of diagnosis, and knows when to use which one. A doctor who only relies on physical examination, because he has no familiarity with MRIs, CAT scans etc, is not one who will inspire confidence in you.
Likewise, today's advisor needs to know and keep himself abreast with a variety of diagnostics that are now available, to help him understand his client better. Knowing them, and knowing when to use which one, is what sets a good advisor apart from the others.
Content is created by Wealth Forum and must not be construed as an opinion by DSP Blackrock MF.
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