Some financial advisors believe that clients’ risk tolerance varies and is subject to market conditions and volatility. After all, nothing tests a client’s resilience like the stressful, real-world bite of a market downturn.
Often, however, it actually is a client’s perception of risk – not his or her appetite for it – that changes, according to a recent research paper entitled Individual Financial Risk Tolerance and the Global Financial Crisis.
Using data from Australia-based FinaMetrica Pty. Ltd., a firm whose psychometric risk test is recognized as the benchmark for effectively measuring client behaviour, authors Paul Gerrans, Robert Faff and Neil Hartnett, professors at three of Australia’s top business schools, looked at the risk tolerances of investors before and after the global financial crisis that began in late 2008.
After controlling for other demographic details – such as gender, income and education – that are known to have some impact on risk tolerance, the authors’ study focused on shifts in client attitudes throughout the period of upheaval.
The study found that although there was a statistically significant decline in risk tolerance through the financial crisis, the change was so small that it did not result in any material shift in behaviour; furthermore, risk tolerance actually remained stable over time.
According to the paper: “The magnitude of changes seen in risk-taking behaviour around the world and the relatively modest change in risk tolerance reported here suggest a larger, more material change in other factors that play a role and contribute toward a change in investor behaviour.”
Several other studies point to risk tolerance being a deeply ingrained personality trait that tends to remain stable – a finding that contradicts the experience of advisors used to dealing with anxious clients looking to modify their portfolios in the face of volatile markets.
That’s because risk tolerance is not the only factor that affects investor behaviour, according to FinaMetrica. In reality, clients are driven equally by their risk perception, mistaken or otherwise.
“Risk tolerance” determines whether clients are willing to take on a specified amount of risk in pursuit of a potential reward.
“Risk perception” is a more subjective evaluation of whether an investment is still in line with the risk tolerance threshold.
If risk tolerance is stable, then you and your clients would be wise to focus more attention on risk perception – and the recency bias that drives it. (“Recency bias” is the undue influence that recent experience can have on decision-making, which may lead clients to project what is happening now into the future irrationally.)
When recency combines with intensity, something behavioural psychologists call “salience,” the effect can be even more powerful.
During bear markets, many clients might choose to sell off at least a portion of a declining portfolio – not because it’s approaching some agreed-upon risk threshold, but because they perceive that the most recent drop is actually the harbinger of a much more significant loss. If such views are not anchored properly, clients’ misperceptions of risk can lead to catastrophic investment decisions.
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