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.