Commonly asked questions on risk tolerance may actually be off the mark
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While assessing a client’s risk tolerance as part and parcel of any financial-planning process, the questions advisors commonly ask may be looking at other aspects of investor behaviour.
Questions that advisors typically ask their clients actually measure different things than risk, argued Meir Statman, professor of finance at Santa Clara University’s Leavey School of Business, in a recent column on the Wall Street Journal. And looking at the wrong baselines, he said, could lead to incorrectly designed investment strategies.
As one example, he discussed the impact recent events could have on investors’ attitude toward particular investments. If a market has been yielding favourable returns lately, then investors asked how they want to invest are more likely to say they want to increase their holdings. On the other hand, poor recent returns will decrease their willingness to invest.
To account for such recency bias, Statman suggested that advisors ask clients about their outlook on market returns for the next 12 months, and then ask how they feel about risks over the same period.
He went on to discuss the difference between risk and regret. He explained that regret — and its opposite, pride — describes a person’s feelings after seeing the outcome of a choice they make. However, these feelings are strong guides “only when there is a strong connection between choice and outcome”; it’s different when luck plays a bigger role, in which case risk applies. Therefore, asking a client how likely they would be to invest in a company that lost them money before measures their susceptibility to regret, not their aversion to risk.
Statman suggested that rather than steering regret-averse clients into low-risk investments, advisors should reduce their susceptibility to those feelings by making them aware of the role that luck plays in investment choices and outcomes.
He also noted that while there’s a relationship between a client’s confidence and their tolerance for risk, advisors should pause before prescribing high-risk investments to confident clients, as there’s a danger of overconfidence. “Overconfident investors perceive risk as lower than less-confident investors, biasing upward the measure of their risk tolerance,” he said.
For that reason, Statman suggested that advisors adjust down their risk-tolerance assessments for confident clients. He also added that such clients might benefit from a little pushback, especially as certain confident investors tend to resist recommendations that they diversify their portfolios.
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