We recently had a request from a long term subscriber John Reilly, the Managing Director of Good Will Financial Services in Bristol to assist in his ongoing due diligence of FinaMetrica's risk profiling integrity..

"Through normal due diligence research, I read this article with an open mind. It became strikingly obvious, when I read a couple of their examples of ‘poor practice’, that they were talking about FinaMetrica (without naming the innocent!). I would be grateful if could respond to these ‘criticisms’ and the other aspects they raise."

We responded:

We see articles like this pop up now and then and while well intended they tend to confuse the subject matter further. Most of the concerns stem from a poor understanding of what risk tolerance is and how it fits into the risk profiling process and psychometric testing. We’ve provided two examples below.
 

The article references the FCA (FSA), paper in 2011. We reviewed the FSA paper and wrote to the FSA to clarify some of the misconceptions around risk tolerance assessment and psychometrics. You can read our comments here. We had no response from the FSA and the guidance was finalised a few months later with no meaningful changes.
 

Our view then and remains now that the FSA paper was a good start to improving risk profiling but set a very low standard. We reviewed all of their comments and decided that we could only reduce the effectiveness of our test if we followed their 'advice'. Hence we’ve made no changes on our end.

For example 1:

Extract from http://adviserbusinessreview.com/risk-profiling-tools-remain-flawed-need-new-approach :

“Compared to others, how much of a risk taker are you?”This question requires the client not only to make a judgement about themselves based on undefined and subjective multiple choiceanswers but also to make a judgement about ‘others’. It is an impossible question!
 

Roszkowski (1992) commented that “another ostensibly straight forward approach to assessing risk tolerance involves asking the client to classify himself or herself with respect to the amount of risk that he or she can tolerance”. It should never be the sole basis for determining a client's risk tolerance, but along with other items, a global self-rating adds to the assessment process because it captures elements that the other items may not be able to tap.
 

Furthermore, the research literature shows that people can to some degree estimate their own risk tolerance among others. Grable et al (2006) conclude: "Self-assessed financial risk tolerance was found to be a statistically significant predictor of general financial risk tolerance, cash holdings, and equity holdings, both by itself and when analysed using control variables. The amount of variance explained by self-assessed risk tolerance, by itself, ranged from 2% for cash holdings to 27% for general risk tolerance." In a study using The American College's Survey of Financial Risk Tolerance, Grable and Roszkowski also found that the correlation between self-assessed risk tolerance and risk tolerance as assessed by the other items in the test to be .41.
 

The LSE analysis of FinaMetrica data shows that the self-rating questions scored very well. They have high correlations with the other items and load strongly on the risk tolerance factor and Doehman (2005) paper provided strong evidence regarding how predictive a global self-assessment of risk tolerance can be.
 

For example 2:
 

Extract from http://adviserbusinessreview.com/risk-profiling-tools-remain-flawed-need-new-approach :

“Is it more important to you that your money keeps its buying power or that you don’t suffer a loss?”This question expects the client to compare two non-opposing factors.Maintaining buying power is not the ‘opposite’ of not suffering a loss. It is like asking, “Do you prefer vegetables or holidays?”
 

The question as presented is poorly worded and requires the contextual explanation before it.
 

We agree with the article that risk profiling is the start of a conversation, a discussion piece; however, the measurement of risk tolerance should be done using a proven scientific discipline like psychometrics.
 

Advisers are responsible for the processes and tools used in formulating advice. Advisers must satisfy themselves that, at a minimum, any tool used is both fit for purpose and true to label. Our Due Diligence Checklist is designed to help you conduct due diligence on any risk tolerance test in the market, including ours, we’ve completed one for FinaMetrica at the end of the checklist for you.
 

Reference
Roszkowski, M. J. How to assess a client’s financial risk tolerance: The basics. Personal financial risk tolerance. Bryn Mawr, PA: The American College, (1992) pages 6 to 7.

Grable, J., Roszkowski, M., Joo, S., O’Neill, B., & Lytton, R. How Well Do Individuals Assess Their Own Risk Tolerance? An Empirical Investigation. Consumer Interests Annual, (American Council on Consumer Interests), (2006), 52, 229

Dohmen, Thomas J., et al. "Individual risk attitudes: New evidence from a large, representative, experimentally-validated survey." (2005).