Insights from Psychology and Psychometrics on Measuring Risk Tolerance

Roszkowski, Michael J.; Davey, Geoff; Grable, John E.
April 2005
Journal of Financial Planning;Apr2005, Vol. 18 Issue 4, p66
Academic Journal
• Despite some arguments to the contrary, a client's financial risk tolerance can be measured accurately by a questionnaire, provided that the questionnaire has been developed in accordance with psychometric principles. • The science of psychometrics has a set of standards by which to judge the quality of a questionnaire .These standards deal with the processes used to create the questionnaire as well as the characteristics of the results produced by the questionnaire. • In questionnaire creation, the questions should be evaluated for their understandability and answerability, and their ability to differentiate between individuals with different levels of risk tolerance. Moreover, the questionnaire in its entirety should be subjected to an evaluation of its adequacy. Adherence to these principles can ensure that the questionnaire's results are both reliable and valid. • Validity and reliability determine quality. A reliable questionnaire measures consistently, with known accuracy. A valid questionnaire measures what it claims to measure .The publisher of a questionnaire should provide evidence of the questionnaire's reliability and validity. • Unfortunately, questionnaires commonly used by financial planners do not adhere to psychometric standards. They are generally too brief (a reliability problem) and contain too many "bad" questions (a validity problem). • Bad questions are those dealing with constructs other than risk tolerance, such as risk capacity (how much risk the client can afford to take), time horizons, liquidity, and goals. Although important to the financial planning process, these issues are not part of the construct of risk tolerance. Questions that require explanation are also bad questions. • Many of the commonly used "investor risk" questionnaires are actually asset allocation calculators mislabelled as risk tolerance tests. • While few planners have the resources to develop and maintain a psychometric... INSET: Executive Summary.


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