Investment Risk Tolerance

"Risk" means different things to different people - danger, uncertainty, opportunity, thrill. In reality, though, there is risk in any situation where there is a chance of experiencing an unfavourable outcome.

We are all aware that, when it comes to taking risks, we each have our own comfort zone. We also know our friends, family members and colleagues often have different comfort zones from our own.

Studies have identified four different categories of risk: financial, physical, social and ethical. Most people behave consistently within a category but not necessarily between categories, e.g. a sky-diver may also be mountain climber but may or may not be a comfortable public speaker.

People react differently to risk. Some are habitually inclined to reject it, others to accept it. Risk tolerance is the level of risk a person will willingly accept. It is best thought of as a continuum, with people ranging from risk-avoiders to risk-seekers.

The whole issue of financial risk is a difficult one. On the one hand, low risk tolerance prevents many people from doing as well as they could financially. On the other, some of life's most unpleasant financial surprises arise because people were exposed to a level of risk beyond their comfort zone, i.e. beyond their risk tolerance.

Unlike, say, height or weight, there is no unit of measurement for risk tolerance. A person's risk tolerance can only be measured relative to others on an artificial scale (in much the same way as IQ is measured.) Someone may know what risks they are, or are not, prepared to take. But they are unlikely to know how this compares to others.

Studies confirm that people generally do not accurately estimate their own risk tolerance (and, not surprisingly, given the difficulties in any communication about an intangible, that their advisers' estimates are less accurate than their own.) While the pattern of estimates is scattered, there is a slight overall tendency to under-estimate. A possible explanation for this is that the majority of the population is, in absolute terms, more risk-avoiding than it is risk-seeking. Faced with a choice between a certain profit and an uncertain but probably larger profit, a sizeable majority chooses the certain (but probably smaller) profit. Someone who in absolute terms is slightly risk-averse may not realise that this is typical of the population as a whole.

An additional difficulty is that, even the meaning of "risk" can depend on the situation. When individuals talk about "risk" as they experience it in their personal financial affairs they are not talking about the same thing as investment researchers discussing the "risk" of an investment.

So we face a double challenge,

firstly, in making an accurate and meaningful assessment of their tolerance of risk as they perceive it, and
secondly, in expressing this assessment in such a way that the risk involved with their current arrangements, and in the decision alternatives now on offer to them, can be evaluated against their risk tolerance.
All fields of human endeavour use measurement in some form, and each field has its own measuring tools measuring units and measuring disciplines.

Risk Tolerance is a psychological trait, as are intelligence, personality, aptitude, attitudes and values. A trait can be defined as any distinguishable, relatively enduring way in which one person varies from another.

Since the early 1900s, psychologists and statisticians have been developing techniques to measure and assess psychological traits. While this development has not been free of controversy, there is now a widely accepted discipline for psychological testing and assessment. The technical quality of any test can now be measured against internationally agreed psychometric standards. A 'good' test is one that is valid and reliable, i.e. it measures what it purports to measure and it does so consistently.

As measuring investment risk is therefore so important we have invested in an internationally recognised Risk Profiling system, called Finametrica.

FinaMetrica's Risk Profiling system has been developed using the disciplines that apply to psychological testing and the test itself exceeds international psychometric standards.

If you are interested in finding out more about this please call us on 0121 685 5060 or complete the contact us page by clicking on the link above.