In 2011, as part of my thesis at the University of Minnesota, I ran an experiment comparing a risk profiler licensed by many broker dealers with a set of behavioral bias questions. You may not be be surprised to learn that the risk profiling instrument told you little about how an investor will behave in various market and economic scenarios. In fact, it showed that in some circumstances it could actually provide completely wrong information.
A few of the most interesting findings were:
- 63% of those assigned a “Growth” risk profile said they would struggle with even minor losses over the next three years.
- 68% of those who expected to keep pace with rising markets also said they could only tolerate small losses.
- 60% of those assigned a “Growth” risk profile also demonstrated significant loss aversion (this is a huge red flag)
Nothing Has Changed
15 years later and apparently nothing has changed. Society improved in many of its ways, but apparently not risk profilers. A report published on MarketWatch detailed out some of the more common issues with today’s risk profilers. It specifically mentions a question in a Fidelity risk profiling instrument, “If the stock market dips 30% or more and takes your account value down with it, how unsettled will you be?”
How unsettled would I be? Psychology has proven that we are awful at projecting how we might feel and act in a future situation. When in a rational state of mind, particularly if we are currently feeling good and confident, we just can’t imagine how bad we will feel, the fear we will experience, and how that will impact our thinking, perceptions, and decisions.
What to Do?
Risk profilers serve their purpose, albeit a small one. They are often required by compliance for advisory accounts and could serve as a starting point to understanding your client’s true risk profile. Unfortunately, many advisors use the risk profiler as the starting and ending point to assessing risk tolerance.
The MarketWatch report said that research has found that investors making poor decisions has more to do with “complexity-driven mistakes rather than true risk preferences.” What are these complexity-driven mistakes? They are our innate biases.
Incorporating questions that help you understand your client’s proclivity to common investor biases may tell you much more about how your client is likely to behave than a risk profiler. At the very least, it will give you some good points to discuss. Our industry loves to scale things. Unfortunately, when we scale we take away the human element and have to make assumptions, such as investor rationality, that cause us to misunderstand who our human clients truly are, what makes them tick, and how we can best guide them to make wise decisions.
AI PROOF YOUR ADVISORY BUSINESS
In one week, I will launch the Behavioral Advisor Academy. The Academy transforms advisors into behavioral advisors with everything they need to become behavioral finance experts and seamlessly apply key concepts in their practice.
49 short video modules on all things behavioral between the advisor and investor. Includes real-life situations with clients, 22 advisor-client scripts through a behavioral lens, 7 behavioral finance tools you can incorporate in your practice, and 13 CE credits (CIMA, CPWA, CIMC, RMA….CFP pending approval).
– JAY
