Risk tolerance is a much talked about area in financial planning and it is one core component of an investor’s unique financial behavior – what we call their Financial DNA. It is so fundamental that we are always talking about it and making decisions with reference to it.
A huge difficulty has been reliably measuring an investor’s risk tolerance. One of the problems is that an investor’s risk tolerance is assessed today but then a portfolio is developed for the long term which has to cope with fluctuating markets. Do you truly know what your client’s risk tolerance for the long term is? How much of your assessment of the client’s risk tolerance is based on current situational factors and their emotional impulses today about the market? Then add in the fact that a person’s risk tolerance may differ across different asset classes. Of course, an advisor’s own risk tolerance can color the situation resulting in the client “eating” the behavior of the advisor. There have been lots of examples where a group of advisors addressing the same case facts at the same time will come up with different risk tolerance assessments for the client.
After more than 10 years of studying financial behaviors, including risk, and performing research based on our online profiles Financial DNA Resources has now launched our “Behavioral Portfolio Report”. You can download a copy of it here: http://financialdnaresources.com/FinancialDirections.
The Behavioral Portfolio Report provides a comprehensive and holistic analysis of a person’s complete financial behavioral style resulting in the creation of what we call an “Inside-Out Portfolio”. The inside-out portfolio gets to the level of asset classes and also tactical factors for investment selection. This then becomes the foundation for the financial plan and investment policy statement.
Fundamental to the Inside Out Portfolio is a superior analysis and quantification of the person’s risk perception and risk attitude. In particular, our analysis uniquely dissects their:
1. Understanding of risk and return – if this is high then they are likely to see investment markets as less risky
2. Risk propensity to take risks (or be bold) – their behavioral inclination to make daring or bold choices
3. Risk tolerance – which is the ability to live with the consequences of taking risks
Interestingly, our research has shown that in 20% of cases people have a higher risk propensity than risk tolerance. This is critical for advisors to know as their client could take greater risks than they can stomach.
Core to our Financial DNA work has been the discovery of a person’s natural “hard-wired” behavior – these are the behaviors that remain stable through a client’s life. This applies equally to risk propensity and risk tolerance.
Recently, we have had people re-take our profiles to determine profile consistency with time gaps of over 3 years. The consistency level has been very high which is powerful considering the turbulent times we have been living in.
It is key to know a client’s natural risk profile for building a portfolio as this is the behavior which will reveal itself when they are under pressure and generally throughout their life. This behavior is highly predictable. However, you do need to know the client’s current financial preferences as well based on experiences and education. This will tell you where they are at now and how much portfolio variance they can accept, and what additional guidance they may need in the portfolio construction phase.
So, our view is that you cannot know enough about your client when you are advising them. Knowing all of the dimensions of the client’s risk attitudes and objectively quantifying them is important for the “know your client rules” and more importantly to be able to have a transparent discussion with your client to properly manage their expectations. Using your intuition is very important but it alone is not enough. Now is the time to start educating your clients with much deeper and applied behavioral insight.