How does risk profiling work?

How does risk profiling work, and why does getting it right matter so much before you invest?

One of the biggest developments in the investing industry today is the rise of so-called robo-advice, automated portfolio management with minimal human interaction. For many people, particularly younger investors without large sums to invest, these online services can work perfectly well. But it's important to understand their limitations, especially when it comes to accurately assessing how much risk you're willing to take.

In this video, Neil Bage, co-founder of Suitable Strategies and an expert on financial behaviour, explains why robo-advice can be more dangerous than it looks. These services are often framed in a very positive, rosy light, making investing sound easy, simple, cost-effective and fully under your control. That enticing presentation, Bage warns, can lull people into decisions they aren't properly equipped to make.

You'll learn why working out your risk profile, your willingness to take risk, is vital before investing, and why an online questionnaire alone often isn't enough. The methodology behind these questionnaires was originally designed for face-to-face conversations, where an adviser can look you in the eye, read your body language, and pick up on the twitches and subtle expressions that reveal far more than ten written answers ever could. Move that process online and you strip out this crucial "whites-of-the-eyes" element, losing a great deal of valuable information in the process.

The video also explains why risk tolerance is so subjective that investors often aren't the best judges of their own attitude to risk. When asked what they'd do in a hypothetical situation, people struggle, because psychology has shown time and again that humans are poor at imagining themselves in a future state and answering with any real authority.

The takeaway: if you're in any doubt, seek professional financial advice. Even if you ultimately decide to invest online, paying for an accurate risk profile is a sensible move. As Bage puts it, these are critical, life-shaping decisions, not a simple choice between tea and coffee, and getting your risk profile wrong can be genuinely damaging. The wise course is to pause and honestly ask yourself whether you're really able to make this decision entirely on your own.

Chapters / Key points

• The rise of robo-advice and where it works well
• Why robo-advice can be more dangerous than it appears
• Why working out your risk profile matters before you invest
• Why an online questionnaire alone often isn't enough
• The value of the "whites-of-the-eyes" face-to-face conversation
• Why body language reveals more than written answers
• Why risk tolerance is so subjective
• Why we're poor at predicting our future selves
• When to seek professional financial advice

Transcript

How does risk profiling work?

Robin Powell: Hello there. Perhaps the biggest development in the investing industry today is the rise of so-called robo-advice, automated portfolio management with minimal human interaction. For many people, particularly younger investors who don't have large amounts of money to invest, these online services are fine. But it's important to beware of their limitations.

Neil Bage is the co-founder of a company called Suitable Strategies and an expert on financial behaviour.

Neil Bage: The robo-advice services that we see, we look at and we think, "Wow, why wouldn't you buy from them? They're making it sound really easy and simple and cost-effective, and I can manage my investments, I've got full control." You know, so it's framed in a very positive and rosy light, they kind of entice you in, and I think that is really quite dangerous.

Robin Powell: Because investing is inherently risky, it's vital to work out your risk profile, in other words, your willingness to take risk, before you invest. For Neil, simply completing an online questionnaire is not sufficient.

Neil Bage: The first problem we have is, in an online world, that methodology was designed for a face-to-face discussion, it was designed for you looking at me, the whites of my eyes, and asking me questions and assessing my attitudes to risk-taking. That's how it was designed. It was never designed to be put into an online world. And what people are doing is, they are taking that methodology and just putting it online and allowing customers to do it themselves. They are removing the whites-of-the-eyes conversation. That's a really crucial missing piece, because the whites-of-the-eyes conversation is more than just asking questions. I can pick up on the twitches in your body, I can pick up on the little movements on your face, so when I ask you a question, I am actually gathering a lot more information than just ten questions.

Robin Powell: Another issue is that a person's risk tolerance is very subjective. An investor isn't necessarily the best judge of his or her attitude to risk.

Neil Bage: We ask people a series of questions and we ask them, "What do you think you would do in this given situation?" And what psychology has proven time and time again is that humans are not very good at putting themselves into a future state and answering a question with any degree of authority. We can't do it.

Robin Powell: The lesson here is that, if you're in any doubt, you should seek professional financial advice. Even if you subsequently decide to invest online, paying for an accurate risk profile is a sensible move.

Neil Bage: People need to be more self-aware and people need to think, "Do you know what? I think I know this, but let me just make sure I do, really." Because these are quite critical questions. This isn't "Do I want a cup of tea or do I want a cup of coffee?" This is a decision that will affect my life for the rest of my life if it goes wrong. If I lose all my money on a bad investment or a bad financial strategy, that's a damaging thing to happen. So what I would suggest people do is kind of stop and say, "Am I really able to make this decision on my own?"

Robin Powell: Thank you to Neil Bage, and to you for watching. Goodbye.