From the October 2011 issue of Investment Advisor • Subscribe!

October 1, 2011

When a Client Is of Two Minds on Risk

Sometimes clients’ intuitive and reflective minds are at odds—How do you even them out?

Client risk tolerance is probably the single most difficult factor for a financial professional to measure and address. When I explored this topic in “Reassessing Risk” (Investment Advisor, November 2009), several advisors I interviewed praised the risk profiling system developed by FinaMetrica, based in Sydney. To shed further light on this topic of risk sensitivity, I recently spoke with Geoff Davey, the co-founder and director of FinaMetrica.

“We all have two different minds, not just about money but about everything: the intuitive mind and the reflective mind,” Davey said. “The intuitive mind is how we react to things emotionally: fight or flight. It’s essentially subconscious, whereas the reflective mind is the thinking mind; it’s how we consciously think about things.”

The intuitive mind has biases that cause us to perceive things inaccurately or process information inaccurately. The reflective mind makes cognitive errors: we miscalculate or misweight things.

Sometimes our intuitive and reflective minds clash. An example is the optical illusion based on two parallel lines, one with an arrowhead on both ends pointing in and the other with arrowheads pointing out. If you look at the two lines without the arrowheads, it’s obvious that they are the same length. But as Davey pointed out, the intuitive mind is very strong. “Even when your reflective mind knows they are the same length, you still see the one with the inward-pointing arrowheads as being longer,” he said.

We both agree that it’s important for financial advisors to educate clients about these biases and the pitfalls that may result. To give IA readers an idea of these pitfalls, I asked Davey to join me in commenting on some situations when a client is “of two minds” about risk.

Q: I recently invited some of my clients on a “Just Guys” golf outing, followed by lunch in a private room at the club. When a discussion of the market began over lunch, I was surprised by the appetite for risk that many clients expressed—even those who have always told me they’re risk averse. How much credence should I give this change of attitude?

A: Davey and I concur in saying, “Absolutely none!” “Risk tolerance correlates with overconfidence,” Davey said. “The more risk tolerant somebody is, the more confident they are likely to be that they are right. In a group, they will be confident, forceful and outgoing, so their opinions will carry more weight than more risk-averse people, who are less apt to be overconfident.”

Focusing on a different aspect of the situation, my view (supported by gender research) is that men in groups are more inclined to take risks. I believe they tend to see risk-taking as a sign of courage. When they get together with other men, that’s no time to trust what they say about risk.

My suggestion is to wait till you are back on home turf. Then meet with each client individually to determine his true risk tolerance.

Q: After reading dire predictions of a no-growth economy, peak oil and higher unemployment, a few clients have asked me what to do if another crash occurs. What are some ways to keep clients from sinking into fear, despair and paralysis again if the worst happens?

A: Davey pointed out that this situation illustrates two biases of the intuitive mind: availability and overreaction. “Availability means that we tend to overweight dramatic information,” he explained. “One of the classic tests is that when you ask people to estimate how many deaths in the United States are caused by shark attacks, the guesses are way too high because these are dramatic events that get reported in the media. The overreaction bias means that we overweight what happened today, as opposed to the historical record.”

If you have any cautionary tales about folks who acted on their fear and went on to regret it, you should share them with your clients. Remind them that if they are acting in their “stress mode,” their decisions will be rooted in panic and will most likely be dysfunctional.

I would also interview each client to develop a list of strategies and sources of support that have enabled them to cope with difficult situations in the past. They will be better able to hear your ideas about defensive portfolios. The combination of emotional and financial preparedness will help them avoid feeling overwhelmed in the future, no matter what happens.

[Read more from Geoff Davey about clients' sensitivity to risk.]

Q: A client couple of mine retired a few years ago with a $4 million portfolio. The husband wants to invest more aggressively. The wife insists that they should be satisfied with what they have instead of taking chances on losing it. I’ve had no luck getting them to compromise on a middle-of-the-road strategy. What would you suggest?

A: “If there’s a big difference between them,” Davey said, “you need to look at whether the husband is average and the wife is unbelievably cautious; or the wife is average and the husband is wildly overconfident.” He suggested that you begin by assessing both clients’ comparative risk tolerance with a tool like his FinaMetrica risk profile. This will show if the wife’s risk aversion falls within the normal range or is extreme. Similarly, profiling will indicate whether the husband is an average risk-taker or is far out on the continuum.

I would propose meeting with each client separately before you profile them. Listen carefully to the personal history, both before and since marriage, that has helped shape their appetite for, or aversion to, risk. Once you understand where each person is coming from, you can help them understand gender differences around risk.

Davey and I fully agree on the value of encouraging these spouses to meet in the middle and decide on a level of risk for most of their portfolio that they can both live with. With the remainder, you can peel off some money that he can take greater risks with, and some that she can invest more conservatively. This will go a long way toward meeting their personal risk preferences.           

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