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De-Mystifying The Multi-Dimensional Nature of An Investor's Risk Profile

What Is The Misunderstanding Of An Investor’s Risk Profile?

In my journey as a wealth mentor over the last 20 years, and developing a rigorous scientifically based behavioral finance approach for the last 15, I have watched the risk profiling discussion seriously evolve from denigration to one that is being more intelligently embraced and applied. From advisors, clients, compliance departments, and regulators: what is the misunderstanding of an investor’s risk profile?

The problem is a combination of factors:

  1. Lack of clarity in the terminology as to what defines risk profile. For instance, interchanging risk tolerance, risk perception, and risk capacity although all have different meanings.
  2. Regulators worldwide have created principles based laws around risk profiling. But the legislative vagueness leaves too much open for interpretation leaving many firms doing virtually nothing.
  3. Compliance departments allowing “tick-the-box” methods of risk profiling along a broad array of approaches from doing nothing, to guessing, observing, or 3-to-5 hacked together questions.
  4. Applying the risk profile in a linear way based on a single measurement.
  5. Lack of understanding risk profiling at a deeper level because many of the instruments and processes are slapdash and poorly constructed. Even the better tools are one dimensional but are used to measure all aspects of risk, which is wrong and misleading.
  6. The Inability of advisors/consultants to integrate risk profiling and behavioral discovery into the client onboarding process.
  7. An unwillingness to have the client invest time in additional questionnaires viewed as distracting from getting on-boarded.
  8. The plethora of online investing platforms leveraging a quick & dirty approach to “knowing the investor” without any real insights.

The positive development now is that there is a heightened awareness of the need to adopt a more formalized behavioral discovery process, recognizing that risk taking, tolerance, and loss aversion are separate and measurable personality traits. And it’s a combination of all the risk factors, along with many cognitive biases, that interplay in how decisions are made.

Further, the compliance environment is requiring a strengthening in processes because the #1 issue on the agenda of regulators is dealing with the increase in investor complaints from a lack of suitability. Suitable solutions will never be able to be satisfactorily offered with demonstrated client buy-in unless EACH of the multi-dimensional elements that make up the risk profile is understood by both the advisor and the client.

For the last 15 years in my role as a wealth mentor, I have been guiding advisors and clients to understand the multi-dimensional nature of their risk profile as highlighted in the table below.

Risk elementsA risk profile is not a single number determined in a vacuum. In fact, it is a quantifiable number made up of many measurable financial and personality based elements. Whether you use the Financial DNA Discovery Process or other platform, I suggest you follow these key steps to identify and apply risk profiling:

  1. Use the client’s long-term risk profile for building a long-term portfolio and predicting how they will intrinsically make decisions over the long term (this is what Daniel Kahneman refers to as the Level 1 behavior). The correct questionnaire structure is absolutely critical to getting this result. In my terms, this is the hard-wired natural DNA Behavior. The questionnaire should be designed and independently validated based on sound psychometric principles.
  2. Understand the short-term risk profile based on current situational attitudes and how the client manages themselves (Kahneman’s Level 2 behavior). This is what many risk tolerance questionnaires seek to measure with varying degrees of quality and accuracy.
  3. Separate the various calculations of the Risk Need to achieve the client’s goals and Risk Capacity being their financial ability to sustain losses from the various personality traits associated with risk, risk propensity (desire to take risks), risk tolerance (emotional ability to live with losses), loss aversion (emotional reaction to markets), risk and product perception (reaction to situations and products ), and risk preferences (personal evaluation of preparedness to take risk in a given situation or with a product).
  4. Know each client’s Risk Composure – how they are feeling during up and down market movements. Some will embrace down markets and others will fear them. Of course, added to this is knowing how to communicate with clients during these different times.
  5. When wealth mentoring the client, help them set purpose based goals that are clearly defined for keeping them focused on what’s important. An IPS can be used as the guide-stick and for getting the client’s emotional buy-in.
  6. Finally, as an advisor, know the influence of your own risk profile and behavioral biases. Your mindset can inadvertently play out with the client whereby over time they eat your risk profile.

Here are other good resources that support the steps highlighted above:

1. OSC Study on Risk Profiling
2. Adopting a 2-dimensional risk tolerance assessment process
3. The sorry state of risk tolerance
4. How to measure risk tolerance

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Dysfunctional Boardroom Behavior – 5 Steps to Manage

A dysfunctional board of directors can cause multiple challenges for any organization.
Industry leaders, celebrities, and subject experts often make up Boards. Many of these individuals are not accustomed to having their opinions challenged. So while they may add credibility, there’re not always a mutual fit.

Dysfunction arises when:

  • Individual behaviors, cognitive biases, decision-making styles and communication styles are not in sync.
  • Decisions are inconsistent or simply not made.
  • Board members have conflicting agendas.
  • There is lack of leadership from the Chair, no mutual respect and lack of trust.
  • Individuals react inappropriately under pressure.
  • Boardroom bullies are not managed or members just sit back and watch.

A 2009 Gallup Research paper revealed a 70% productivity gain when groups of people working together understood and were able to close the behavior performance gap. This study holds true today.

Every board plays an integral role in the success of the organization. When Board members are dysfunctional and not engaged, the flow on to the organization can be significant.

5 Steps to managing boardroom behavior.

  1. Commit to being behaviorally smart in the boardroom.
  2. Use a validated natural discovery process to assess key personality traits.
  3. Use the outcomes to build a balanced relationship between all players.
  4. Appoint a highly skilled facilitator to work with individual directors to understand communication and behavioral styles.
  5. Commit to building a culture of understanding, acceptance, and respect.

Understanding different personalities can lead to better decision-making. Directors cannot fulfill their responsibilities in a boardroom where a few dysfunctional members are allowed to control the meeting or obstruct board decision-making.

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4 Hacks For Managing Your Nightmare Clients

Advisors and their staff love to stereotype their clients. Without even realizing it, most firms segment their clients based on communication style using a crude method of stereotyping. While this segmentation is informal, it 100% aligns to the four fundamental client communication styles. Below is a guide to the four most common client communication styles and how to serve them based on their common stereotypes. Any seasoned advisor will agree that these tips can save your client relationship.

1. The Engineer: By far, the most common stereotype I hear is “the engineers”. Many firms will avoid engineers at all costs. But for firms that have mastered communication to engineers, this is their bread and butter business. The key many firms use when training new staff is: “don’t you dare show up to a meeting for an engineer without doing your homework.”

Tips for working with “The Engineer” (The information focused)

  • Make the meeting have structure, provide an agenda ahead of time.
  • Provide research to back up recommendations. Give them space to review the research and contemplate options. Ask leading questions to draw them out beyond simple yes/no options.
  • Follow-up the meeting with additional resources to educate themselves and a to-do list as “homework”.
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2. The Talker: The “talker” can be a potentially great referral source, but they sure can do a number on your calendar!

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Tips for working with “The Talker” (the Lifestyle focused)

  • Make the meeting fun and inspiring.
  • Swap stories of influential people that share a similar situation.
  • Follow-up the meeting with a phone call, even invite them to a social event. Everyone likes the life of the party, or at least wants to hear what they’ll say next.

3. Mr. or Ms. Guarantee: Averse to risk, Mr. or Ms. Guarantee cant stand the thought of losses and immediately jump to the worst case scenario. They wont like the idea of complete uncertainty and will often ask for written guarantees and whole-heartedly compare their performance to benchmarks. They need continuous reminders to stick to their plan and that slight ups and downs are normal.

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Tips for working with “Mr. or Ms. Guarantee” (the Stability-focused)

  • Make the meeting relaxed. Use a coffee table or living room type setting.
  • Reference past experiences and make recommendations accordingly.
  • Follow-up the meeting with a phone call AND email about next steps.

4. The Hardheaded: “Do as I do, not as I say”. The hardheaded have a view of the world that every rule is intended to be broken. These clients are the best selective listeners in the world and will interject on a dime to keep the discussion focused on their self-centered plans goals.

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Tips for working with “The Hardheaded” (The goal-setting focused)

  • Make the meeting formal and focus on how you will meet THEIR goals for returns.
  • Be prepared with a sample big picture plan.
  • Afterward, follow-up with an email or text summarizing the discussion.

 

 

 

Following these guidelines will keep most client experiences on the right path to success. But if you ever find you can’t quite find the right fit, either try a mix of the options above, or there are tools and training available to support your needs.

Managing The Rise In Clients Non-Financial Issues

Pull Up The Couch For Your Next Financial Client

According to David Dubofsky, Ph.D., CFA, and Lyle Sussman, Ph.D. in their study, “The Changing Role of the Financial Planner Part 1: From Financial Analytics to Coaching and Life Planning”, approximately 25% percent of the financial advisor’s contact with clients is devoted to non-financial issues. About 74% percent of planners estimate that the amount of time they are spending on these issues has increased over the last five years. Source

There is mounting evidence to show that financial advisors indeed have to radically change their approach to the way they relate to investors.

Money has always been a ‘touchy’ ‘emotional’ subject. Whether discussions resolve around – making it, losing it, sharing it, incorrectly quoting about it i.e. “money is the root of all evil” when the correct quote is, “For the love of money is a root of all kinds of evil.” Timothy 6:10 – the topic can become toxic.

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Why then are we surprised (as I was) to find financial therapists popping up in our world? Or why do we think that financial advisors need to know all about our life and emotional state like a doctor? Is it unlike the mechanic that inquires about our driving habits as part of diagnosing a problem, or advising if those squeaky brakes need to be changed sooner than later? In that case, we’ve surrounded ourselves with all sorts of professionals and experts, acting as doctors and therapists to help us along in meeting our daily needs and lifelong goals.

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Source Photographer: Josh Dickinson

Well, it’s actually quite simple really: the majority of us have no idea what triggers we inherently have that govern the way we manage our finances. We would be alarmed to know we have inherent behavioral biases. We would cringe at the thought of having allowed the bankruptcy our grandparents suffered to dictate the ugliness with which we now accumulate and “store” our wealth.

But take heart these triggers can be revealed, they can be managed and we can work with our financial advisors to develop plans to create wealth that line up with our life goals and values.

In his book Behaviorally Smart Financial Planning: Behavioral Finance Made Practical for Advisors’ Hugh Massie makes the following comment, “Observations and traditional risk profiles don’t get below the surface where much about investor behavior is hidden. Financial advisors should know how to uncover what is happening as investors think through’ decisions.”

The truth is financial advisors need to know how to uncover what lies below the surface of our decision making. They need to know what historical events impact our view of creating/managing wealth. So yes, they do have to approach the advisor/investor relationship a bit differently today. But here’s the good news, they don’t have to spend 8 years or so studying to become a doctor.

The right tools and training for uncovering our core natural behavior is the key. For example, DNA Behavior International has a significant discovery platform called Financial DNA that reliably discovers all dimensions of an investor’s financial personality and inherent bias for making life and financial decisions. The discovery process is fast and accurate and places vital information in the hands of financial advisors before the first meeting with their investor clients.

Investors need an advisor who can guide them towards making informed decisions, one who speaks to them in a style that’s easily relatable while mitigating emotional, kneejerk responses. Emotion plays a significant role in so many parts of our lives that having an investor to coach us through the feelings and reactions, and keep decision making on the right track is necessary.

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Source

Financial advisors must understand their clients at a deeper level. It is essential to have a practical understanding of the psychology, emotions and biases that significantly influence investor’s imperfect decision-making patterns. Furthermore, advisors should understand how to recognize and manage their own biases when working with investors.

Ultimately, it is fair to say that the role of the financial advisor has changed, and will continue to do so. But there is no doubt that with a reputable and appropriate process, advisors can be well informed in advance of a first investor meeting.

Conversations around money will always be complex. While we talk more freely about other intimate subjects, when money enters the conversation, emotion, distorted stories, ego, and even fear enter right along with it.

In conclusion, if we understand our financial behavior then we can balance our emotions and beliefs. We will act more wisely with our money. Conversely, if we lack understanding and are confused about why we make certain decisions, then the decisions will be poor, creating financial chaos and discontent. Advisors need to be fully equipped and prepared to unravel investor’s complex issues around money. Investors need to be able to trust advisors in order to reveal information.

Advise Your Advisor On How To Advise You On Financial Advice

Advise Your Advisor On How To Advise You On Financial Advice

Your Advisor’s not telling you that your long-term financial goals may be out of sync with the level of risk you’re willing to take in order to reach them. No risk, no reward, right? It’s time to advise your advisor on how to advise you on financial advice.

According to a recent survey by asset manager Natixis, while about 73% of investors polled said that pursuing returns is more important, nearly 84% also said they would choose safety over risk.

So how can you balance increasing assets vs. tolerating risk? And how do you relate this to your advisor? For financial advisors, this balance presents a challenge as well. How your advisor is able to accurately assess this is by delving into your core natural risk propensity and tolerance, part of your financial personality.

The opportunity is to educate your advisor on realistic expectations and strategies to best reach your goals. And while he or she has the tools and training available to them in order to help you along, not everyone is onboard with matching your individual personality behaviors with your personal financial goals.

Where advisors often fall short is not identifying all of the risks associated with your particular situation: investment, financial, and personality risks. This is an important factor because under stress, you might not be as clearheaded or know all the ins and outs of a given situation in order to rationally process what’s happening and make behaviorally smart decisions. You very well may be operating based on your core natural behavior.

As you’re transitioning jobs, getting married, buying a house or preparing for retirement, you’re under a lot of financial stress – worries regarding accumulating wealth may push you into new, riskier investment decisions. Then add market volatility, unforeseen personal events or escalating college tuitions or long-term health care costs, or the emotions associated with being in the “withdrawal stage” rather than “accumulation phase”, and you’re pushed according to your core natural behavior. In many cases, this mix of stress and decisions based on your reaction to that stress is not beneficial for the long-term success of financial goals.

Your financial advisor needs to be in a position to manage not only your portfolio, but protect you from your natural self. This is an important step in the investor/advisor relationship and necessary to your financial success, because under stress, your risk behavior is less predictable without an objective tool. You may want to jump at every opportunity, or over-spend, or take no action at all. This is where knowing your behavioral insights and communication style, help your advisor help you and your significant other.

In many cases, a couples’ behavior will be directly opposite one another. So there is an added challenge for your advisor to know the behavior of each of you in order to address both in different ways.

So, how do you uncover these behavioral risks?

You need an objective, third party system so that your behavior, under stress, becomes more predictable and therefore can plan accordingly. Then, in combination with your experience and wisdom, discovering your financial natural behavior will allow you to become a behaviorally smart investor and provide valuable insights to your financial profile. It’s an enlightening process to see if your advisor is right for you, and then in turn, to see if you’re a match to them. And who knows? With these insights, you may find out a lot more about yourself and your partner, than you’d previously known.

Be sure to discover all of your risks originating from your natural core behavior. It’s the only way to protect you, from yourself. And it helps establish a trusting relationship with your advisor to create a financial plan that is as unique as you.

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Be-Fi for the DIYI (Behavioral Finance for the Do-It-Yourself Investor)

The oldest advice in the financial world: buy low, and sell high. And easy to follow too, right? Then how come we’re not all gazillionaires? That’s the Behavioral Finance $25,000 question.

First off, maybe a gazillion bucks isn’t everyone’s goal, but even moderate growth on savings over time in preparation for retirement shouldn’t mean we suffer losses over and over again along the way. So beyond market volatility, what are the factors for our repeated or short-sighted poor finance decisions?

Let me share a story.

Years ago I got a “hot stock tip” from a buddy, stop me if you’ve heard this one before. Between his recommendation and the historical value showing nothing but upward mobility, why not? Well, it hit. A solid 34% gain in just about a month. Amazing, right? I was so excited, I could barely wait to see what it would do next. And that’s the turning point. A couple of dips later, I still had a significant gain, but I was going to ride it all the way back up. It had to bounce back, right? That’s optimism bias. So to remove myself from further discouragement, I opted to not check it daily, even weekly. And in about the same amount of time of its rise to greatness, it dipped to pennies on the dollar below my initial buy-in. What happened? I got greedy? I didn’t set limits (gain or loss)? I got caught in the Herd-following bias. I was following the lead of the others instead of the hard facts, or following a set plan.

Well, I finally got around to telling my Financial Advisor. Even though she’s entrusted with my long-term savings plans, I’d not considered sharing my “fun experiment.” She took one look at the company’s performance and simply said “they’re awful, sell it while you still have something. And next time, check with me first”. Good advice, but not what I wanted to hear. So, I kept it anyway, even in light of overwhelming odds. That’s Overconfidence Bias.

It’s been almost 6 years of hanging onto to this one-time trading nightmare. At least, we weren’t “missing” the money, just sad to have seemingly blown the wad. On a positive note, I’m on the cusp of another big potential return. A rental house we bought at the bottom of the market and now, with a little elbow grease, is primed for resale. Bought, mind you, with our Financial Advisor’s full support. It’s our backup plan if we both lose our jobs and need to get out of our big, nice house quick. We could downsize finances in a hurry. Anyway, the silver lining, since I’ve held onto the dog of a stock, is to sell it when we sell the house and take the stock loss to offset the house profit. Not brain surgery, but in sync with our advisor’s input.

A nice story about Behavioral Bias and advisor communication, but let’s get back to the Financial Personality of a person who might seem to haphazardly buy high and sell low, when they meant to do otherwise, and how this affects long-term financial planning efforts.

Our Financial Personality covers both innate and learned behaviors in regards to our financial decisions. It also includes our behavioral biases, communication style, and Market Mood. So knowing one’s Financial Personality is the key to developing financial goals and then the plan to achieve them. This transparency in truly understanding ourselves helps us navigate volatile market events and stay on point for the greater good. Your Financial Advisor has assessment tools that can quantify your personality traits. There’s a self-guided version posted here (personal assessment) to try for yourself.

 

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Another integral part in working with your Financial Advisor, or any business colleague, friend neighbor or significant other, is communication. Recall that I included my advisor on the house purchase, but I only spoke with friends on the stock ordeal? Well, we all have our own communication style. And we tend to run in circles where our own style is fairly prevalent — learned from families and developed amongst friends. But in the business world, good communication is key to being understood, and understanding others. And we won’t always get to choose to (or from) whom we engage. So we have to learn to adapt (or be left behind). Wouldn’t you want a way to identify how you come across to others or how best for others to engage you? Well, there are assessment tools for this too. Again, here (communication style) is an assessment you can try, and even share with others.

It’s no coincidence that I included the interactions with my Financial Advisor as part of my financial thrill of victory and agony of defeat. She was and continues to be in my corner for staying on course and avoid making bad decisions when the terrain suddenly changes. And some mistakes have wholly been on my own. Now, this may not be the case for everyone, and that’s why we’re kicking off this discussion — to find the peaks and valleys of our financial journeys and help one another along the way. If you’re interested in seeking an advisor, or already have one, and want to share what’s being discussed here, please check out this advisor finder.

 

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Likewise, tune in for more Behavioral Finance for the DIY Investor over the next several weeks as we cover the many ways our Financial Personality, Behavioral Biases and Communication Styles affect, and are affected by, our relationships with our friends, family, Business and Financial Advisors.