Markets May Be Volatile, but Risk Tolerance Isn’t

FinaMetrica study suggests client risk tolerance is remarkably stable

Determining a client's risk tolerance is a standard requirement in financial services, both as a matter of best practices, and regulatory minimums. In recent years, though, advisors have increasingly leaned towards doing the minimum required to assess client risk tolerance, due to the frustration that client risk tolerance itself has varied wildly through the bull and bear market cycles of recent years.

However, a new study from FinaMetrica from before and after the global financial crisis joins a growing body of research suggesting that in reality, client risk tolerance is actually remarkably stable, and that what's changing through market cycles is not the client's risk tolerance, but instead risk perceptions. The significant implications of the research are that planners struggling with unstable client investment behaviors around risk—e.g., buying more in bull markets and selling out in market declines—may actually need to focus more on managing risk perceptions, rather than blaming the instability of client risk tolerance.

The inspiration for today's blog post is a recent research paper entitled "Individual Financial Risk Tolerance and the Global Financial Crisis" by Australian academics Paul Gerrans, Robert Faff and Neil Hartnett. The authors looked at the financial risk tolerances of 4,741 investors before and after the global financial crisis in late 2008, using global investor data available from FinaMetrica, arguably the world's leading (and most rigorous and scientifically validated) risk tolerance assessment tool.

Evaluating Risk Tolerance Over Time 

To assess whether risk tolerance changed as a result of the financial crisis, the authors controlled extensively for other demographic details, from gender to wealth to income to education, all of which have been separately shown to have some impact on financial risk tolerance. This narrowed their data set down to 3,368 investors who were tested both before and after the financial crisis with complete demographic data.

The results of the study found that technically, a minuscule but statistically significant decline in risk tolerance did occur through the financial crisis, but the change was so small that it would not likely lead to any observable difference in behavior and was effectively "stable" over time. This is consistent with other research done using FinaMetrica data, and FinaMetrica's own analysis that despite volatility of the world markets, average risk tolerance has remained stable.

The very slight downward trend visible in the data is due primarily to the inclusion of U.S. investors (in 2002) and U.K. investors (in 2004), who in the aggregate tend to be slightly less risk tolerant than the Australian investors that dominate the early years of data, and consequently bias the average downward as more of them are included in the total. (Notably, separate research has shown that as investors age, their risk tolerance also declines slightly, and that major life events can affect risk tolerance as well, so an aging sample of investors through the financial crisis would also show a slight downward trend over time.)

To say the least, though, there appears to be no apparent correlation between the trend in risk tolerance and the trend in the world index through the 2002 and 2008 bear markets, or their subsequent recoveries. In tomorrow’s post, we’ll look at risk tolerance and client behavior, as well implications of the study for clients.

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