There are now lots of automatic investment providers that offer cheap and easy investment management. They normally begin with a ‘risk assessment’ which consists of asking you to choose your risk profile on an ascending risk scale scale of 1-5 or 1-10. The risk scale is calibrated to the degree of market volatility. This strikes me as beyond naive. In an earlier blog I concluded that market volatility was not necessarily very important to someone saving for retirement or investing primarily for income. For many people that regard themselves as risk averse, the correct choice is in fact 10. The correct choice depends on far more than simply presumed attitude to market volatility.
In choosing a level of risk one begins with the objective. The risk assessment should be relative to not achieving the objective. The risk choice should be calibrated to the the seriousness for the individual of not achieving the objective. This has two components. First, the inherent uncertainty in the chosen strategy. Second, and most important, the interaction between this uncertainty and behavioural responses of the investor. Market volatility may play an important role in behavioural interactions. Hence, a well designed strategy for a clear objective may be thwarted because the investor panics at the first sign of mark to market loss. The strategy is abandoned, the objective lost, and quite probably a loss incurred. The problem is that no one knows how an investor will respond, least of all the investor.
The response of investors to mark to market losses or gains is neither known with certainty in advance nor necessarily stable. Asking investors to choose a risk preference in advance is a futile and potentially dangerous exercise. It may excuse the manager responsibility for what happens after investment but it does help the investor. The latter do not know their response to mark to market losses (or gains for that matter). Nor can they be sure to respond in the same way in all contexts. There is for example a well known tendency to protect gains and run losses. The investment strategy needs to account for potential investor behavioural response and the risk choice needs to be set at a level that ensures the strategy is not abandoned. Of course objectives change (birth, death, marriage, divorce) and some degree of flexibility must be built into the strategy in any event.
One route would be to use psychometric assessment to identify potential behavioural responses. Such assessments could be included on automatic investment websites. The investor could choose their risk preference and then complete the psychometric questionnaire. The questionnaire would either validate the initial choice or give the investor food for thought. The website could offer advice based on the objective and the questionnaire result. It seems to me that automated investment platforms must sooner or later involve psychometric assessment of risk preference as a perquisite. The problem is that suitable questionnaires are not yet available. There is a market gap for psychometrics methinks.