How to measure risk tolerance the ‘right’ way

By Paul Nixon, Head of Behavioural Finance at Momentum Investments

Measuring behavioural risk capacity – or how composed a client will be in the face of market turbulence – is often ignored when a risk profile is compiled. The two other benchmarks that are also overlooked and painted with the same brush are the two very different concepts of risk tolerance and risk perception.  

Risk tolerance is a person’s long-term and stable attitude towards risk and, if measured, should give the same result in a market crunch or market surge. Just like your personality does not change a person’s attitude to risk, in general, do not either.

Risk perception, on the other hand, is how much risk the client is feeling in markets at the time of measuring their attitude. In other words, a short term and changeable feeling or view.

But why is it important to measure a client’s risk tolerance? Simply put, it will help advisers to give the ‘right’ advice based on the client’s personality and attitude towards investments. It will also assist financial advisers in guiding clients gently in the right direction to avoid behaviour tax: Switching between funds when the going gets tough or clients’ emotions get the better of them, which could negatively affect investments.

Momentum Investments latest Sci-Fi report described the 2022 period of analysis of investment behaviour on the Momentum Wealth platform as ‘behaviour tax loading’. A recent example is that investors dramatically de-risked their portfolios in 2022 and left equity markets when the ALSI was at 64 000 points. At the time of writing, it is, however, breaking records at over 80 000, which means switching back to risk assets realises the behaviour tax.

How do you do it?

How does one measure these attitudes towards risks and investing? The answer is simple: With properly researched and constructed personality assessment tools. Poorly designed instruments, of which there are many, lead to inconsistent outcomes. These instruments often confuse perceived and apparent risk tolerance, which in turn could lead to advisers disengaging with these instruments.

The ‘right’ way

The only ‘right’ way to design these tools is psychometrically to limit variation and inaccuracies. Constructing the tools is as much about the process as the outcome. Classical test theory in psychology is based on the notion that the score an individual gets from a test has two distinct parts: The first is the true score and the second is measurement error.

The true score (such as measuring an attitude) can never be observed (only approximated) and the observed score will begin to resemble the true score as measurement error decreases.

To do this, the instrument should provide an outcome that is both reliable and valid. These are critical in the psychometric process.

Reliability refers to how much (or little) measurement error we are prepared to tolerate. The primary sources of measurement error stem from the test questions themselves.

Validity is the extent to which the tool measures what it was designed to measure. For example, are the items or questions related to the idea or concept? If the instrument is testing risk tolerance or risk attitudes, for example, and is asking questions about the investor’s time horizon or cash flow needs, the construct validity is low because these considerations (while important) will reveal virtually nothing about the investor’s risk tolerance or attitudes.

In collaboration with the University of Pretoria, Momentum Investments will soon launch the first South African designed and psychometrically-tested investment behavioural fingerprint. This diagnostic instrument can be used to test attitudes and gain insights into clients’ investment behaviour. With us, investing is personal. You cannot get more personal than a fingerprint.

Momentum Investments is part of Momentum Metropolitan Life Limited, an authorised financial services and registered credit provider (FSP 6406).