Markets May Be Volatile, but Risk Tolerance Isn’t, Pt. 2

For many planners, the idea that risk tolerance is a stable trait appears to defy the personal experience of working with clients who materially change their portfolios in the face of volatile markets. “If risk tolerance is stable,” they argue, “why can’t clients stick with their investments?”

The simple answer is that the trait of risk tolerance is not the only factor that affects investor behavior. Instead, investors are ultimately driven by two factors: their risk tolerance and their risk perception. Risk tolerance determines whether the client is willing to take a specified risk in pursuit of a potential reward. Risk perception is the client’s subjective evaluation of whether a particular investment is consistent with that risk tolerance.

For instance, imagine a client whose risk tolerance indicates that it is acceptable to invest in a portfolio that may decline as much as 20%, in order to pursue a long-term return that is 2% higher than a more conservative alternative. In theory, any and every investment that meets this trade-off—can generate a 2% higher return, and is unlikely to decline more than 20%—should be appealing to the investor.

But now let’s assume that we’re in the middle of a bear market, and the investment in question has just declined 15%. As the behavioral finance research has shown, we have an irrational tendency to overweight what has happened recently, and project it into the indefinite future. As a result, the investor might choose to sell the investment that has declined—not because it violated the client’s 20% decline risk tolerance threshold, but because the client’s perception is that the current 15% decline might just be the first step of a 25%, 35%, 50%, or 100% loss! In other words, the client perceives the investment to have become intolerable, not because the tolerance changed, but because the perception of risk changed.

In a similar manner, clients in the midst of a bull market tend to be remarkably willing to invest in “riskier” assets. The common assumption is that clients are more tolerant of risk when markets are performing well, but the research paper ”Individual Financial Risk Tolerance and the Global Financial Crisis” by Australian academics Paul Gerrans, Robert Faff and Neil Hartnett reveals that is not the case. Instead, the real problem is that when markets are rising and clients provide undue focus to only recent events, clients begin to form the assumption that such investments will always and only go up. Accordingly, even the “ riskiest” of investments don’t appear to be risky at all, and the investor buys them… again, not because the tolerance for risk increased, but because the perception of risk decreased.

Implications for Clients