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

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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

In a world where risk tolerance is stable but risk perception varies, the real challenge of difficult clients is in managing their fluctuating risk (mis-)perceptions. If views of risk and expectations are not anchored properly, the client’s potential misperceptions of risk – especially because of the prevalence of the recency bias – can lead to wildly inappropriate investment decisions and a greed-fear buy-sell cycle.

Notably, the difficulty in separating risk tolerance from risk perception also suggests that objective and rigorous measures of risk tolerance, such as FinaMetrica’s assessment tool, are crucial. Otherwise, in practice, it may be almost impossible to determine from a subjective conversation alone whether the client is truly risk tolerant, or is risk adverse but misperceiving the actual risks involved. The research on the stability of risk tolerance also suggests that questionnaires showing client risk tolerance was rising and falling through market cycles may have been a reflection of the poor quality of the questionnaire, rather than actual risk tolerance changes of the client.

The bottom line is that this latest research puts another nail into the coffin burying the idea that risk tolerance fluctuates up and down with the vicissitudes of the market (adding to the body of research on the topic that FinaMetrica summarizes here). The research reveals that instead, client risk tolerance is actually stable – and can be measured effectively with the right tools – and that what advisors and their clients must focus on the most is risk perception. Accordingly, best practices should include evaluating risk tolerance, designing a portfolio consistent with that risk tolerance, and then providing the ongoing communication necessary to ensure the client continues to correctly perceive the risk of that portfolio, fighting the natural tendencies to over- and under-estimate the risk over time.

So what do you think? If risk tolerance is stable but risk perception varies, would that change how you communicate with clients? Do you try to assess risk tolerance and risk perception separately? How do you communicate regarding risk perception?

See part one of Michael Kitces’ blog on this topic.

For more on the topic of risk tolerance and risk perception, see Geoff Davey of FinaMetrica’s latest blog for AdvisorOne.