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Knowing you better than you know yourself

Assessing a client’s true appetite for risk can itself be a perilous proposition, but advanced technology and clever thinking can get you closer to the truth.

5 November 2016 / Technology

Think back to your student days. When facing an exam question, part of the game was second-guessing what the marker might want to read. It was about scoring good marks, not really about getting to the truth.

So unsurprisingly, when asked to sum up their attitude to risk, many clients tend to provide answers that reflect what they think their wealth manager expects. They may also provide responses that are biased by their often inaccurate view of themselves. Their answers can potentially skew investment decisions that come back to haunt them – and they may well blame their investment adviser for the result.

Questions, questions, questions

Such biases can be weeded out and corrected by wealth managers who get to know their clients over a long period of time and make allowances in their investment advice and decision-making. But the personal attention of an experienced private banker is not something everyone can afford, and even the most skilled adviser can benefit from help in reaching those decisions. Fortunately for the majority of people now seeking to invest, and their advisers, technology powered by behavioural finance can help.

Dolfin’s Head of Product Development, Valentin Vincendon, explains: “By asking seemingly neutral questions that are anchored in real-life situations, we can delve deep into investors’ psyches and ensure that they feel emotionally comfortable throughout their investment journey.”

The study of behavioural finance and the development of technology that seeks to get under an individual’s skin and understand what makes them tick are increasingly gaining credence. One of the early leaders in the field is Greg B. Davies, founder of Centapse, a consultancy that specialises in applying behavioural science to financial decision-making. “Risk tolerance, correctly understood and measured, is a simple, stable psychometric trait, and best assessed with simple psychometric questions,” he advises.

Too often, however, the questions that are asked in an attempt to assess clients’ appetite for risk are superficial and subject to bias. The four-stage questionnaire developed by Dolfin and built into its platform uses in-depth, subtle analysis of the respondent’s replies to establish:

  • clients’ circumstances;
  • what advice and help they think they require;
  • what they might actually require; and
  • their knowledge of financial and investment matters.

Davies emphasises the importance of treating the results of any such questionnaire with care “The whole purpose of measuring risk tolerance is to establish investors’ stable long-term preferences for trading off risk versus return. And yet, most actual behaviour is short-term, extremely unstable, and highly influenced by framing, context, and biases. It is vital to understand these short-term emotional responses to markets…but as a route to helping them overcome myopic actions, not to blindly bake these into a recommended investment solution.”

No wrong answers

Vincendon describes key attributes of the questioning process. The questions cover a broad range of potential respondents by age, wealth, sex and other criteria, with this set of questions kept as neutral as possible. The questions are limited in number, and anchored in real-life situations, so respondents’ self-perception can be ruled out and they cannot deviate from their true response. Finally, a scale of interpretation is built to measure the responses and match them to investment preferences. The whole process is revisited at regular intervals, using methods derived from econometrics, to compare their reactions over time so that their profiles can be updated and enriched.

“Clever though it is, this questionnaire-based process is just one part of a balanced investment solution,” stresses Vincendon. “It empowers advisers with additional insight into their client’s true preferences. But that knowledge needs to be combined with other considerations – not least the client’s ultimate investment objective – as well as regular and personal contact in order to form a well-rounded view of a client’s risk appetite and offer considered investment recommendations.”

Although not a panacea then, using behavioural finance certainly improves decision-making, enabling the adviser to get just a little bit closer to knowing a client better than they know themselves.

About Greg B. Davies

A specialist in applied decision science and behavioural finance, turning academic insight into practical applications. With a prior background in academia and consulting, in 2006 Davies started, and for a decade led, the banking world’s first behavioural finance team as Head of Behavioural-Quant Finance at Barclays. He holds a PhD in Behavioural Decision Theory from Cambridge; is an Associate Fellow at Oxford’s Saïd Business School; a lecturer at Imperial College London; and author of Behavioral Investment Management.

Mr Davies’ views in this article are independent and not an endorsement of Dolfin’s approach to behavioural finance or technology – neither of which he is familiar with.

What would you do?

You have bought a ticket for a concert that will take place in six months’ time. The performer is a major international star and the ticket has cost you £1,000. Forgetting that you have bought the ticket however, you spend £50 on a ticket to see another performance, on the same evening, by someone whose work you love.

Eventually realising that you’ve double-booked and that it is too late to get a refund on either of the tickets, which concert would you chose to go to?

Your answer reveals your true preferences by distinguishing between a decision based upon the amount of sunk, irrecoverable cost and the performer you really prefer.

You have decided to buy a particular model and colour of car that you like. On visiting the showroom you are told that they have the exact model you want. It is available right away but not in the colour you like. However, the car in your chosen colour will be available to buy in six months’ time. Would you buy the model that is available now or would you wait for the one in your preferred colour?

Your answer to this question will indicate your capacity to delay reward in order to achieve your ideal. The financial parallel is called ‘discount rate’, it’s the interest you have to be paid in the future to renounce the immediate enjoyment of a sum of money. Some people might settle with 0.1% per year, others need 10 or 20%.

If you were given the choice to watch a comedy or a drama tonight, which would you choose? How confident do you feel you would make the same decision on the same date one year from now?

Your answer reveals your trust in your own consistency. Human beings are usually not very consistent, but they believe they are.

The questions, answers and explanations above are given as an example only, and in practice will be used in combination with a number of questions and factors to assist in determining a client’s risk appetite.

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Founded as a London-based wealth boutique in 2013, today we’re a diversified financial services firm with an international presence and our own bespoke technology platform.

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