An article from LIA's The Advantage magazine by Paul Resnik and Stuart Erskine, FinaMetrica
In an ideal world of perfect information, there would be no need for risk tolerance testing, a client would be able to articulate their appetite for investment risk clearly. However, clients often have little financial knowledge therefore tools exist to enable exploration of clients’ risk tolerance.
Paul Resnik, through his research, has concluded that most advisers score a higher risk tolerance than their clients.
So, to avoid advisers projecting their bias onto the client to take more risk it is important to use a third-party tool. Risk tolerance is a personality trait for how much risk one is willing to take in financial matters. The underlying assumptions to most risk profiling tools is that risk tolerance is normally distributed. The average person has average risk tolerance. Therefore, most tools are in effect concerned with identifying the exceptions (higher or lower) away from the average.
Psychometrics is a social science; it is an art, not an exact science; it is the methodology that deals with the measurement of personality and attitudes including the application to testing (investment) risk tolerance.
Defining (Financial) Risk Tolerance, Risk Capacity, and Risk Required:
Risk Tolerance is often used as a catchall term for many risk-related concepts. The International Organization for Standardization (2006) defines financial risk tolerance as the extent to which someone is willing to experience a less favourable outcome in the pursuit of an outcome with more favourable attributes. When framed this way, financial risk tolerance is distinct from concepts such as risk preference, perception, capacity, need, or composure.
The Importance of Using a Reliable Risk Tolerance Test
The objective of risk profiling to improve client outcomes is defeated if the risk tolerance test itself is not fit for purpose. The authors have listed a link to the due diligence checklist which will help guide the adviser to select a reliable and effective tool.
The starting point for due diligence is “On reading the questions in the questionnaire: Do they make sense to you? Can you understand them?” If not, then there may be an issue; clients may struggle to interpret the questions. The UK regulator has a good perspective derived from consultation with the advice industry.
“Some firms unduly focus on the risk a customer is willing to take and fail to take sufficient account of the customer’s other needs, objectives and circumstances. While attitude to risk is an important consideration, suitability is not just about making investment selections that reflect a customer’s attitude to risk” The UK Regulator is The Financial Conduct Authority (FCA) Assessing paper.
Example of Good Practice:
“A firm produced regular management information on the results of the risk-profiling tool used. It included information on how the results are distributed across the different risk categories and how this compares to what would be expected given the firm’s customer base. It also included information
on the number of customers whose final risk categorisation is different to that indicated by the tool including information on the numbers that have moved by more than one category.” FCA Assessing Suitability.
So, there are circumstances in which the portfolio can be different from what the risk tolerance score suggests. For example, many clients may not be able to achieve their investment goals, so they have the option of changing the amount they invest, changing the time frame, or changing the risk level they are prepared to accept or combination of all of these factors. Paul Resnik has developed five suitability proofs3; guidelines to ensure that customers’ needs are at the centre of the advice process:
01 Prove you know the client’s circumstances, needs and aspirations
Advisers need to have a thorough understanding of a client’s circumstances, goals, risk tolerance and risk capacity. The client’s goals include financial and lifestyle goals.
Prove you have explored alternative financial behaviours and strategies
More often than not, clients can’t achieve their goals with the resources that they have available. Here, advisers must explore alternatives with clients and the possibility of achieving goals through different means. The trade-off decisions themselves must be made by the client according to his or her values rather than by the adviser, who is there to guide the process.
03 Prove you know the products and services being recommended to a client
Once you have decided on an investment strategy, you must be able to prove that you know the products and services being recommended to the client as part of that. Importantly, the adviser must explain product details to the client in a language they are likely to understand.
04 Prove you have explained to the client the risks in the plan and the products through which the plan will be implemented
The adviser must show they have explained to the client the risks in the financial plan. Clients need a clear understanding of the expected performance of investments and, in particular, the downside risk on their portfolio.
05 Prove you received the client’s properly informed consent to accept those risks
The adviser needs to demonstrate with evidence that the client has given their informed consent to the plan and that the risks have been fully explained and the client has accepted those risks.
Knowledge of human behaviour, particularly bias in decision making is important for advisers to understand:
We know humans are not rational, our emotions influence our decision making. It is important for advisers to have awareness of some natural human biases as risk profiling and the advice process exist to improve client decision making and improve outcomes; in effect to overcome bias.
Relating to financial matters, bias can be understood as decision-making that leads to sub-optimal outcomes. For example, present bias may lead to impulsive spending now, so that people don’t save sufficiently for retirement, because they give little weight to future events.
Individuals do not necessarily act rationally and consider all available information in the decision-making process because they are influenced by behavioural bias.
People can be thought of as engaging in two types of thinking when making a choice between, say, different investment opportunities. System 1 involves “intuitive” thinking which
is fast, automatic, relatively uncontrolled. System 2 thinking (“reasoning”) is slow, deliberate and controlled. Whilst consumers do use both types of thinking, it is normally system 1 which governs much decision making.
Some Examples of Relevant Biases:
- Loss-Aversion: People tend to strongly prefer avoiding losses than obtaining gains. The implications of loss-aversion are clients over-represent safe investments and under-represent risky investments in their portfolios.
- Bandwagon Effect: This is a form of herd instinct, described as gaining comfort in something because many other people do (or believe) the same - individual decision making is influenced by the crowd. It’s why financial bubbles exist.
- Anchoring Bias: The tendency to rely too heavily on a past reference or one piece of information when making a decision.
- Risk Composure: This describes how a client will actually behave when faced with financial loss. The likelihood is that in a perceived crisis, individuals will have a tendency to behave emotionally which is fundamentally different to their rational self. Often, reflecting on the client’s past behaviour during a previous market downturn can be one of the best predictors of their true tolerance for risk.
- Overconfidence Bias: Occurs when a client’s confidence in their own judgements is greater than the objective accuracy of those judgments; it can lead to bad investment choices resulting from failure to recognise informational disadvantages, an under-reaction to new information, over- investment in speculative markets and excessive trading volumes (especially in bull markets).
This article first appeared in the November 2022 issue of The Advantage magazine, an exclusive benefit to LIA members.