A significant challenge facing investment advice has been the relatively poor measurement of client risk preferences or tolerance as a component of investment suitability.
The suitability of an investment for a client involves four components. The required return and associated risk to reach an investment goal is fairly straightforward and may be conducted with a cash flow analysis. But what about things like risk tolerance, risk capacity and emotional risk capacity? Do we all agree on exactly what these constituents are and how to measure them?
In a study conducted by Momentum Investments and global decision science experts Oxford Risk in the UK, we found that there was a lot of noise or variability in the adviser assessment of risk capacity or the clients financial ability to take investment risk. Coupled with this was high variability in translating the risk tolerance score provided in a case study format to a corresponding equity allocation in the investment advice provided. Irrespective of the risk tolerance score provided, equity allocations ranged all the way from 0% to 100%.
How then, should risk tolerance be measured?
Risk tolerance is our willingness to take on investment risk. This should reveal the baseline for our risk preferences, and represents our attitude towards risk – we like risk, or we don’t. Attitude-behaviour models show that our preferences represent stable attitudes towards behaviours and risk behaviour is no different. In other words, risk tolerance, if measured correctly, only needs to be measured once (in general).
Willingness to take risk, or risk tolerance, is linked to our personality. Personality theory has been shown to be a good predictor of financial behaviour as well.
A quick example should illustrate this. The dimension of our personality that refers to our impulsivity and spontaneity is termed ‘openness’. If you have the ‘openness’ trait you are likely spontaneous but also very present-oriented. These people want to experience life now and generally don’t mind taking investment risk. Being present-oriented, though, also means they don’t look at the future much and therefore saving behaviour does not come naturally.
The link between personality and risk tolerance is a crucial link to make because personality by nature has one extremely important characteristic – it is stable. Personality only changes in the event of trauma but generally everyone knows “you” as “you” because of your personality or set of characteristic behaviours. This is important because this is exactly what the industry has gotten so wrong when measuring risk tolerance.
The link between personality and risk tolerance is a crucial link to make because personality by nature has one extremely important characteristic – it is stable.
Providing things like hypothetical win-loss situations in risk tolerance assessments doesn’t measure risk tolerance but rather measures risk perception. How you perceive risk can change. And if you measure something that can change and match it to a long term or static investment goal, at some point you’re going to have a very unhappy client.
Stability in risk tolerance has been shown in several research papers, but one by the CFA institute* deserves attention. During the Global Financial Crisis (GFC), a group of respondents was surveyed to track if and how they were engaging with their savings. Participants in the survey were asked how risky they perceived markets to be during the GFC and predictably subjective risk expectations clearly showed that people were perceiving more and more risk in markets during 2008 and then much less and less as markets recovered in 2009.
The respondents’ return expectations also increased as optimism returned to financial markets. Their risk perceptions were not stable at all and this was reflected in the percentage allocated to equities – increasingly less during the GFC and increasingly more as markets recovered. The study also conducted risk tolerance questionnaires at various points with a psychometric assessment. People maintained their risk seeking or risk averse attitudes (risk tolerance) throughout the crisis.
Making investing truly personal is more than just a strapline at Momentum Investments. Developing a deeper understanding of human behaviour for better advice outcomes is what keeps us doing what we’re doing – helping advisers help their clients to achieve their investment goals.
Developing a deeper understanding of human behaviour for better advice outcomes is what keeps us doing what we’re doing – helping advisers help their clients to achieve their investment goals.
Watch this space as we get closer to delivering a world class psychometric risk profiler to the adviser community that give insights about stable client risk preferences and their likely reactions to market events.
*Weber, E.U. and Klement, J., 2018. Risk tolerance and circumstances. CFA Institute Research Foundation.
Momentum Investments is part of Momentum Metropolitan Life Limited, an authorised financial services and registered credit provider (FSP 6406)