Risk Tolerance

Investment Risks Rooted In Human Behavior

A statement I have been making to many people for the last 10 years is: “Investment markets cannot be controlled, but how you manage your reaction to them can be”.

Generally, for most investors the reason that they obtain returns which are on average 6% lower than market returns is because of their behavior. Investors generally make poor investment decisions because of their reactions to events and also to their own life circumstances. This can be because they do not know who they are or how to manage their emotional impulses which are driven from how they are wired to behave. I really want to emphasize that successful investing is about managing your behavior.

If you are an advisor, it is about predicting and managing your client’s behavior and also managing your own behavior. So when you talk about managing investment risk, what you are really talking about is managing BOTH human behavior and the market risks. This is fundamental to the value proposition for obtaining advice from an advisor. Clearly, it is important that the advisor also has a high degree of financial emotional intelligence.

Traditionally, when risk is talked about in investing, everyone talks about market risks and to some degree investor risk tolerance. The reality is that there are so many more risks which need to be addressed which all have an impact on the investment decisions made. These additional risks are behavioral. To make the point, I have prepared the following table which highlights many of the “Investment Impact Risks” that can influence investment decisions and ultimately the investment returns a person achieves. This is what needs to be managed.

Click Here for the illustration.

So, there is a very strong case for every person to have behavioral guidance from an advisor no matter how knowledgeable or experienced they are with investments. The behavioral guide or what we call a “wealth mentor” needs to have a true understanding of a person’s Financial DNA which is their financial behavioral style. The Financial DNA is shaped from genetics, early life experiences and then overall life experiences, values and education. At a broad level, the behavioral information that needs to be discovered is in the following categories of information, as they all impact the investment decisions made in some way.

The reason we advocate that investors and advisors (the behavioral guide) complete behavioral profiles early in the advisory process is because they provide objective and measurable insights into the complete financial behavioral style on a holistic basis. With a good behavioral profile, not only is the risk tolerance discovered, but also completely who the person is at a much deeper level than what any normal person can reliably do on their own. You truly get below the surface. Remember, no matter how evolved you are personally, we all have blind spots and biases. Very often clients “eat” the behavior of the advisor. So, the advisory process becomes dangerous if the advisor is not aware of his or her blind spots.

Which ever angle you come from they all lead to the point that investment risks are rooted in human behavior.

Managing Your Clients Through Turbulent Times

Well the stock market has gone to 10 year lows. Has it hit the bottom? That is not necessarily the crucial issue although this downward spiral will be raising more fears. What is crucial is how you handle this situation in terms of your own behavior and managing that of your clients. If you read my last blog you will see research is showing that advisors are on the whole not going far enough in client discovery and in particular understanding behavior.

Here are some tips for managing your clients which are all based on having greater behavioral understanding:

  1. Help your client to objectively face the reality of their situation. This requires understanding how they will innately respond to times of change and difficulty. Are they a rational decision-maker or a procrastinator?
  2. To make your clients feel comfortable and respond to your advice communicate on their terms not through your lens.
  3. Re-evaluate your clients risk tolerance – most measures of risk tolerance are situational. You really want to know their hard-wired risk tolerance as this will be the paradigm from which they make decisions now and in the future.
  4. Build a behavioral portfolio for your clients – base the asset allocation on who they are.
  5. Review the clients product suitability from a behavioral standpoint.
  6. Re-build the overall financial plan recognizing who the client is and their changed circumstances.
  7. Critical to helping your clients move forward is to help them find what their true life purpose is. After all they will still be breathing tomorrow. So lets get a positive state of mind on how they will live their life.
  8. Review your client service team. Have you got “round pegs in round holes” for serving the clients? The advisor client match process is very important.
  9. Transform the client experience you provide. Look how you can make every aspect of it totally client centric and you will be amazed at the bottom line results.
  10. Project positive energy and confidence. This means being very comfortable with who you are and your planning approach. People like animals sense fears and will react.

Remember times of change and difficulty bring opportunity. Are you up to it?

Uncovering Human Behavior Risks

Generally in business, and particularly in financial services, people associate risk with the markets or economy. What we fail to drill down into are the risks caused by human behavior. Another way of looking at this is to consider how people handle the market risks. What decisions do they make? What solutions do they come up with? How do they manage their emotions? How do they communicate?

In essence, the market risks can be managed or exacerbated by human behavior. So, what needs to be better understood is how your people are going to handle market and economic risks that may be impacting your business. This will be particularly important when they are under pressure. What are their blind spots? What are your blind spots? Then, how will you manage your people so the risks are better managed?

Through our Financial DNA profiles we are able to reliably predict how people will behave and therefore the risks they may cause. Will they take too many chances? Will they be too impatient? Are they too independent and not accountable? We have found that the profiles are able to provide great insights into the true behavior of people when they are under pressure. Having this information can help you put in place the right management controls and also to provide the individuals with more self-awareness of how they will make decisions which could cause or exacerbate market risks. There is no doubt a large part of the success or failure of businesses in the long term comes down to being aware of and managing human behavior. You only have to look at some of the major corporate and banking disasters to see this.

So how aware are you of the risks that your people could be causing to the future of your business?

Managing Risk

On the weekend, I had the great fortune to listen to a very inspiring presentation by Dr. Ben Carson. Dr. Carson is a leading pediatric neurosurgeon at the John Hopkins Hospital. In his career he has been a pioneer in performing highly risky surgery on children. He has a great book: “Take the Risk – Learning to Identify, Choose and Live with Acceptable Risk”.

Dr. Carson explained how he has often been faced with addressing the viability of taking a major risk in his work. What is there to gain? Will it be worthwhile? What if I fail? He made the insightful comment that if no one took a risk then today there would be no airplanes or cars or other technologies. Society always benefits from someone taking risks as lessons can be learned.

Is ducking risk the most productive way to live? Nothing will be achieved without taking risks. However, nothing will be achieved by taking inappropriate risks. The question then becomes what is an acceptable risk? In this regard, what is an acceptable risk to people will be different because we are all unique. Dr. Carson says you need to build your risk analysis model based on who you are, your values and also your learning style.

All of the principles Dr. Carson states can be equally applied to determining your financial risk tolerance and how you make financial decisions. The quality of life you build for yourself will be somewhat dependent on the risks you take. Ultimately, what is an acceptable financial risk will come down to your relationship to money. Further you and your partner need to check your “couple compatibility” index so that the risks taken are acceptable to both of you.