Most of us have come across psychometric testing at some point, although not necessarily as part of your financial planning process. Psychometric testing is an important – if sometimes complex, and often misunderstood – part of financial planning for both financial planners and clients alike.
In this two-part blog series, we’re going to explain how and why we think psychometric testing is so important when assessing investment risk and how to make sure the test that you take, is suitable and fit for purpose.
Psychometric testing as part of your financial planning
Our psychometric test is part of our overall assessing investment risk process. At its heart, that process involves 3 key elements (or 3 pieces of the puzzle):
- An assessment of your individual level of risk tolerance – on an emotional level,
- An evaluation of your capacity for risk – how would it affect you financially if your portfolio fell in value, and
- A thorough knowledge of all your assets and income – both now and in the future.
Why assess your risk tolerance
Accurately assessing investment risk is an absolutely essential part of financial planning for three reasons. Firstly, it enables us to provide you with the best possible service, recommending an investment portfolio that meets your future needs and goals but doesn’t expose you to unnecessary risk or a level of risk that would make you feel uncomfortable.
Your level of risk tolerance means the extent to which you feel emotionally comfortable with taking a risk with your investments in order to reap the rewards you want or need.
Secondly, it means that right from the outset, you’re able to make more informed financial decisions and your increased insight, means as the markets go through their natural highs and lows, you’ll have a greater understanding of how and if this affects you and whether or not you should react.
Finally, we also believe risk tolerance assessment forms part of our moral obligation to you – when we work with a client, it’s nearly always on a long-term basis and it forms part of our ongoing obligation to really understand you and what makes you tick, so we can ensure our service always meets your needs, both emotional and financial.
But how does assessing investment risk work?
Your level of risk tolerance means the extent to which you feel emotionally comfortable with taking a risk with your investments in order to reap the rewards you want or need. Your ability to tolerate risk is a personality trait and on the whole, they don’t change.
Education, age and experience tend to have little impact on your risk tolerance. But it can be very hard to accurately assess your own risk tolerance, particularly when you’re thinking about events in the distant future or events that you’ve never experienced. And, what you perceive the risk to be, is different to what your tolerance of risk actually is.
Another complicating factor is that financial planners and fund managers can tend to have higher levels of risk tolerance than their clients. And without independent intervention, they can unknowingly project those higher levels of tolerance onto their clients.
The risk profiling tools we use provide a scientific way of ensuring we really know and understand our clients right from the outset and have an accurate picture of how you would feel in any number of given situations.
Once we know how emotionally comfortable you are with investing, we can then integrate that with our knowledge of your entire financial picture
Bringing the three pieces of the assessing investment risk puzzle together
Once we know how emotionally comfortable you are with investing, we can then integrate that with our knowledge of your entire financial picture (including liabilities, investment assets, non-investment assets, anticipated future income and expenditure etc.).
Then we slot in the final piece of the puzzle – how financially able you are to withstand risk (your risk capacity). In other words, how would it effect you financially (how and if you could cope) if your investment portfolio dropped in value.
We have a vast body of evidence and information about the history of our recommended portfolios and products and how they would have performed over the last 50 years or so – including the normal returns, highs, lows, the worst falls and how long recovery periods took. We use this information to demonstrate the worst and best case scenarios in respect of your portfolio’s likely future performance.
With all three pieces of the puzzle in place, it means we can predict what effect it would have on you financially in various situations and how you would feel about it. That in turn enables us to recommend an investment portfolio that meets your needs on all levels: financially and emotionally, now and long term.
Assessing investment risk is a fundamentally sensible process and an integral part of what we call our systematic approach to investing. Our aim is that your investments should achieve your long-term goals. But we also want to provide you with ongoing peace of mind.