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RISK PROFILING THROUGH A BEHAVIORALFINANCE LEN
RiskProfiling through a BehavioralFinance Lens
MichaelPompian, CFA Mercer
St. Louis, MO
SUMMARY
In the firstpiece in thisseries, “Investor RiskProfiling: An Overview,” JoachimKlement set forth the challenges that traditional risk tolerance questionnaires present to advisers and their clients. He showed that the currentstandard process of risk profilingthrough questionnaires is highlyunreliable and typically explains less than 15% of the variation in risky assets betweeninvestors. Klement explained that the cause of these deficien- cies isprimarily the design of the questionnaires, which focus on socioeconomic vari- ables and hypothetical scenariosto elicit the investor’s behavior. Incontrast, research in risk profiling has shown that several other factors canprovide more accurate and reliable insight into the risk profiles of investors.
Among these factorsare (1) the investor’s lifetimefinancial experiences (including the most recent period’s return and volatility of markets), (2)the investor’s past financial decisions, and (3) the influence of family,friends, and advisers. An additional factor,which is the subject of this article, is the psychological temperamentof the individual investor; thus, risk tolerance is viewed througha behavioral financelens in the article.With a better understanding ofbehavioral finance vis-à-vis risk taking, practitioners can enhance theirunderstanding of client preferences and better inform their recom- mendationsof investment strategies and products.
INTRODUCTION
We have seen a powerful recovery inasset prices in the wake of the global financial crisis (GFC). Lest we forget, however,more than $15 trillion in asset values evaporatedin 2008–2009, wiping out gainsearned in the bull marketsof the 1990s and early2000s. Clients were shell shocked, often frozen like deer in theheadlights as to what to do. And just as history has shown, marketsare cyclical and another bear market will occur
again—it is just a matter of time. When times are good, asthey have been for the past seven years,our skills as financial professionals can get dull because we have not had to dealwith panicky, stressed-out clients. But it is crucialto “stay on top of our game” and keepour skills sharp. That is what this article is all about—staying sharp and doing thebest possible job for our clients by incorporating behavioral finance into our practice. I havebeen doing so for over 15 years, and it has paid large dividendsfor me.
Understanding how investors make investment decisions is no longera “nice-to-have” skill. Inthis new era of volatile markets, financial advisers must be able to diagnoseirrational behaviors and advise theirclients accordingly. Do you have trouble believing that? Consider that many top advisersacross the globeare already applyingbehavioral finance to their practice. A number of years ago, I surveyed290 sophisticated finan- cial advisers1 in 30 countries to ask them abouttheir interest in and use of behavioral finance with respect to their clients:93% of advisers surveyed reported that theywere aware of key behavioral finance biases, and 94% were usingbehavioral finance prin- ciples with their clients. Some less experienced andquantitatively oriented advisers, however, are needlessly struggling with understanding their clients’ behavior. Assessing risk tolerance is not just the client’sjob; it is also the adviser’s job to interpretbehavior and make adjustments accordingly. This article providesinformation that you, as an adviser, can use to help clients through the trickybusiness of managing their behaviorto maximize the chances of attaining theirlong-term financial goals.
BEHAVIORAL FINANCE
Behavioral financeattempts to understand and explain actual investor behavior, in contrast to theorizing aboutinvestor behavior. It differs fromtraditional (or standard) finance, which is based on assumptions of howinvestors and markets should behave. Behavioral financeis about understanding how people make decisions, both individu- ally and collectively. By understanding how investorsand markets behave, it may be possible to modifyor adapt to these behaviors in order to improve economicoutcomes.
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