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June 30, 2006 at 08:00 PM
Financial counselors ask new clients about their risk tolerance. The client responds by saying he is risk-averse or a risk-taker or somewhere in between. However, the amount of risk a person will take is not set in stone; it fluctuates over time. In fact, the way in which a product is presented to the person will help determine his risk tolerance on any given day.
How could an individual decide to take a gamble on Tuesday that wouldn’t be taken on Monday? A lot of it has to do with a thing called “projection bias,” which is a fancy term for saying humans tend to take what is happening today and project it into the future. For example, if a coin lands heads up nine times in a row, people want to believe the coin will also show its head on the 10th flip, even though the laws of probability say landing on the tail side is just as likely.
There have been several studies done showing that individuals are more willing to take risks in a raging bull stock market and less likely when the market has turned bearish, even though from a rational economic point of view there should be less risk in the bear market because prices have already fallen. Folks tend to extrapolate out both the bull and bear markets forever and thus see the future as either less risky or more risky than it really is.
Knowing how people think about risk should impact the way financial products are presented. For example, if the lead story in the media for the last month has been about recent losses in the stock market – and the advisor is going to present a mutual fund – it would be helpful if the advisor could begin with details of the fund’s past positive performance to offset the current negative market news (and of course reminding the client that past performance does not predict the future). Or, if the counselor is going to talk about a fixed annuity because the client is strongly averse to loss, the discussion should initially focus on the guarantees and safety of the fixed annuity before talking about the interest rate offered.
