Whenever you give investment recommendations, you assume an obligation to make sure that your selections are suitable for your clients. One factor that you probably consider is their tolerance for risk. How might clients react if their accounts lost 10%, 20%, or more? Would they understand that it was just a bump in the road to long-term growth, or would they fall into deep depression and put all of their money in a savings account, never to invest again? And what if the markets took a big upswing? Would they get caught up in the frenzy and make overly-speculative investments?
A client risk profile is a well-known tool designed to help financial advisors understand how clients feel about money. But can you rely on clients’ replies to tell you how their emotions will stand up to an extended bull or bear market? Is the computer-generated analysis of clients’ responses nothing more that a wobbly crutch for advisors who are looking for simple answers to a complex question?
Inaccurate Results
A psychological testing firm did a study of clients who had completed risk profiles. They concluded that the financial advisors’ estimates of their clients’ risk tolerance were accurate in less than half the cases; were slightly accurate in one out of three; and were significantly inaccurate in one out of six.
The researchers also found that the short form investor risk profiles (like those offered by some financial institutions and the online guys) are generally unreliable and inaccurate, and they do not give a true picture of a client’s tolerance for risk and should be avoided.
Garbage In, Garbage Out
The risk profile questionnaires may ask clients to pick how much risk they would be willing to take to reach their goals. This is based on the foundation that clients will expect higher returns for taking greater risk. However, an investment strategy using this analogy may not be appropriate for all of your clients.
A study completed by Hersh Shefrin and Mario L. Belotti, Santa Clara University, concluded just the opposite. The two discovered that the observed investors actually expected higher returns from safer stocks than from riskier ones, even though they had stated otherwise. Would a risk profile questionnaire have caught this anomaly? It’s doubtful because clients’ risk tolerance level scores will only tell you what they perceive their comfort level to be at the very moment that they’re answering the questions.
Left Brain vs. Right Brain
Your clients have a dominate side of their brain that controls how they process information. Each side of the brain has its own unique and special abilities. The right side of the brain is spontaneous and acts on emotion, while the left side of the brain is logical and looks at facts and figures.
Clients complete the risk profile questionnaire in the comfort of their homes or in your office. Typically their left brain, which does the logical and analytical thinking, may cause them to answer rationally but possibly underestimate their ability to withstand bear market pain.
But what happens when emotions take over, such as during a severe market change? The right brain might become dominant and allow fears and dreams to override the left side’s ability to reason. So even though they said on your risk profile questionnaire (which they may have completed in the middle of a bull market) that they would “buy more” if their portfolio fell 40%, they are now in your office freaking out, telling you to sell everything. So much for the investor risk profile questionnaire.
Overconfidence=Overreaction
Investment selection is certainly important. Equally important is how your clients behave after they buy the securities. And investor behavior often is not rational—a characteristic than cannot be brought out in a risk profile questionnaire.
For instance, people typically have positive attitudes, thus they tend to underestimate the likelihood of a bad event. This built-in optimism may cause them to sell a stock that went up so that they can become more confident in their investment savvy. But at the same time, it could prevent them from dumping stocks that have little chance of recovery.
Which Investment Strategy is Best?
If you know that your clients may not always behave rationally, how can you come up with an investment portfolio that is suitable?
A do-it-yourself risk evaluation profile or an online version will take you out of the loop. And shouldn’t clients expect you to sit down with them face to face? If you’re just going to mail something to them or tell them to go online, why do they even need you?
It is often difficult for clients to verbally describe their attitudes about risk. This is because they may not know their financial selves, therefore they lack understanding on the financial risks that they are willing to assume. Maybe you need to look further than a one-size-fits-all form to comprehend clients’ reasons for investing.
Ask your clients about each investment they own. Why did they buy it? How do they feel about it now? How has it performed? Is it how they had expected? What would cause them to sell it? What’s the best investment they ever owned? The worst? Don’t be judgmental. Each of your clients is an individual and should be understood with his or her unique needs and attitudes in mind. Keep your poker face if a client tells you that he lost a bundle on a penny stock that his brother-in-law sold him. Uncover emotional ties, such as inherited stocks.
Have your clients’ attitudes about investing changed over the years? The outcomes of previous investment decisions, family changes, and age can influence how clients view risk compared to what they may have felt 10 or 20 years ago.
Ask your clients if they lose sleep during a drop in the market. Do they look at their quarterly statements, or do they leave them unopened and throw them in a drawer because even glancing at them would be too painful?
Work with your clients to develop a game plan that describes when they should sell a stock. Try to agree what circumstances might change this strategy. This may keep them from overacting to short-term events. And if they are tempted to override the plan, remind them of poor decisions that they might have made in the past. Let them know that you are only trying to prevent them from making the same mistake again.
Analyzing risks involves person-to-person communication and is not an exact science. But your in-person judgements of their emotional states will be far better than the static risk profile questionnaire. Those who want you to believe that you can identify a client’s true risk tolerance scientifically through a questionnaire are mistaken. Your clients are more likely to remain comfortable with an investment plan that fits their investment personality and emotional risk tolerance. And if you can expose those feeling with the right questions, and implement a suitable portfolio, your clients will stick with you through all kinds of market cycles.
Your clients react emotionally and will never be logical.
Tags: risk profile, risk profiles
This is a timely post. Reminds me of another blog post I saw recently: http://www.behaviorgap.com/the-myth-of-risk-tolerance/
My belief is that an investor’s “risk tolerance” is merely a snapshot in time of their current feelings which are too heavily influenced by current market and economic events. Investors are more “tolerant” during up markets and less so in down markets.
The solution, I think, is to forget the risk tolerance questionnaires and let a client’s financial plan – based on what’s most important to them – drive the investment strategy and not how they scored on a multiple choice questionnaire.
I’ve added your blog to my RSS reader and look forward to reading your future posts.
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this is truth that Investor Risk Profiles are Useless..i appreciate…
Investing according to me is a risk which needs to pay off. Sometimes its works and sometimes it doesn’t. The information given here will be very helpful every one who reads it.
Investor risk profiles proved themselves useless last summer. When Lehmen brothers collapsed investors across the board sold absolutely everything regardless of market conditions.
Where were these investors with all the risk tolerance? People scare too easily.
I dont think that investor risk profiles are completely useless… They do provide some slight information about the client, and used with other information like previous investments etc you can create your own reasoning for the type of risk the client is willing to make.
Interesting post. Indeed, emotions play an enormous part in the risk tolerance, and if not careful, risk tolerance will fluctuate with the emotions.
That’s why sitting down with your client, getting them on the right page and the same level is important because it will even out these fluctuations. Unfortunately, too many people are affected by emotions and end up losing big.
Regards
Interesting post! some times the risk will works and some times not.
This is truth that sometimes Investor Risk Profiles are Useless..i appreciate… The information given here is very helpful to the reader…….
Honestly from long time I`m not giving investment recommendations to anyone. I had bad experiences in past, and the true with recommendations is that when they will out, probably they are included in market price…so it`s to late to byu..but for people they can be some proof that financial situatuon of company is good, but like we know everything can change…sorry for my english
Investor risk profiles are becoming less and less useful. For a client, no matter what his risk profile a good investment strategy is one that earns. When it hits a bump they will not be happy. I dont think that has to do with their risk profiles. Whether they react to the hit depends on what kind of ground work the advisor has performed…at least in my opinion.
Yeah, I am also not a fan of investor risk profiling. I think the best strategy is to invest for the long term. Preferably after a significant dip. The end of 2008 would have been a good time
As an investor, I can comment on my own interpretation of “assumed risk”. I can recall filling out a questionere for my financial planner, and there were several questions asked that all led to how much risk could I tolerate. I answered them (I was open to some small market fluctuations) as best I could and my planner placed my funds in about 5 different mutual funds. This was long before the “economy hit the fan” and my account did very well. When it bottomed out, I was down about 40%, but I stayed in and have pretty much recovered all. The main point I am making here though, is that I had complete trust in my planner, and knew that he was doing his best to protect me, regardless what my risk tolerance may have been at the beginning. So, I guess I agree with you partially on that point, when the original questionnere is completed, the risk tolerance is that particular point in time and when things go bad, it changes quickly.
I dont think something that is just a complex graph can actually predict how or if a person can take damage in the investment market… it has way too many dimensions to the reaction to tell the result from prediction.
When I saw the title of this post I immediately thought, “every investor has different risk preferences” (apparently the same thing you thought). I’m not sure why someone would take investment advice from someone else anyways. Everyone should do their own due diligence
I agree that investor risk profiles are useless. What strikes me is the fact that there are investments that are readily available to the public that are guaranteed by the FDIC yet not that many are taking advantage of them. You would think this would be a must considering the climate and the returns regular savings accounts are offering. Any thoughts on this?
I found that when I brought on an assistant last year it really made a big difference. It freed me up to do the things that were important to my business. Writing good articles, updating the website, only doing consultations with pre screened and qualified clients. Now I don’t know how I used to do things without her.
A few years ago, 5 investors begged me for months to take their money and trade it for them. I refused first, but after a few months of them insisting on me and after i explained that trading stocks is not a guarantee that they will make money and they could lose most of their investment. They accepted the facts and handed me their money. I took the first trade and made 2000 for each of them but did not have the chance to tell them. in less than a month, one of them and on behalf of the rest called me and told me that they thought about it and found that they could not take the risk and they want their money back. I never mentioned to him that we were in the money and told hem that i’ll return the money. I gave them their initial capital with 2000 extra for each. when they so the profit, they told me that if they knew, they would have not asked for the money. I said it was ok and that i would not be able to take this responsibility.
Moral of the story, no matter what risk profile you have on hand, fear will take control eventually.
Pretty much agree with you, risk profiles aren’t worth much, but then again I usually take huge risks i lost everything once, but most of teh time I’ve made a lot of money. Worth the risk I guess.
Interesting post. The reason why I said this I believe this investor profiles. And this thing make me reach success.
“My belief is that an investor’s “risk tolerance” is merely a snapshot in time of their current feelings which are too heavily influenced by current market and economic events. Investors are more “tolerant” during up markets and less so in down markets.
The solution, I think, is to forget the risk tolerance questionnaires and let a client’s financial plan – based on what’s most important to them – drive the investment strategy and not how they scored on a multiple choice questionnaire.”
I would tend to agree. Currently we are seeing a very unique bear run and safer clients are pushing some money to the potentially larger gains in small cap investments. I’ve had a lot of clients using the reports at http://www.microcapreports.com/ to find the right stocks for them.
I agree. Investor risk profiles are not a good idea. If the economy goes wrong, it doesn’t matter how safe you wanted to play it, you could still lose out. Who would have though some of the major banks would crash like they did in 2008?
I completely agree with you. Personally I think Investor Risk Profiles are Useless.
I totally agree that risk analysis is based on individual to individual and that aggregate investor risk profiles simply don’t work.
Yeah investor risk profiles are not a good idea in my view, they don’t do a lot for you. Like you said in this article, their results are just too inaccurate..
The risk for the investor is that the risky company’s credit profile improves dramatically or that it is acquired by a stronger company.
Without the credit swap the investor could have sold the bond cashing in on it’s increased price. This is an opportunity cost.
According to me, one of the better known investment strategies is buy and hold. Buy and hold is a long term investment strategy, based on the concept that in the long run equity markets give a good rate of return despite periods of volatility or decline.
I might have bleaker view. Looks like the market is dead? I mean for us average Joes. All the fundamentals do not matter anymore becuz they are either bad or complete bogus.
For wallstreet crooks with supercomputers it’s probably a dream come true. They can do everything with their computer buy, short, naked short, front run, fake bid, fake trend etc etc and no one can monitor them but themselves. Can’t trust anything.
The solution, I think, is to forget the risk tolerance questionnaires and let a client’s financial plan – based on what’s most important to them – drive the investment strategy and not how they scored on a multiple choice questionnaire.”
Being a customer should come naturally to people. It is an experience we all share, but our history as consumers–passive and transactional–is poor preparation for managing a professional services relationship.
It is simple to rattle off the qualities of a great client: open, positive, unafraid to ask questions, accountable, knowledgeable about the client organization, possessing of character and integrity, and seeing the value in providing candid feedback.
A client’s risk tolerance is a snapshot in time, changing with the daily market report. It’s best to follow the client’s long-term financial investment plan based on retirement needs/goals, with frequent communication and updates to that plan.
My belief is that an investor’s risk tolerance is merely a snapshot in time of their current feelings which are too heavily influenced by current market and economic events. Based on the concept that in the long run equity markets give a good rate of return despite periods of volatility or decline.
I agree with the comments above, the Investor Risk Profile does not really help and is useless. I believe that before having an investment plan that achieves greater results and minimum risks, an investor must have detailed understanding of the economic situation.
I agree with Rachel above. One should not let current stocks market conditions influence investment patterns. Short term active traders like myself rely on market volatility to determine variables such as position size, but the average investor in the market for the long term needs to focus on staying the course, and not shy away from making investments when times are tough. Equities will continue to produce the best rate of return over the long haul.
I dont think something that is just a complex graph can actually predict how or if a person can take damage in the investment market. The risk for the investor is that the risky company’s credit profile improves dramatically or that it is acquired by a stronger company.
The promoters of risk profiling have argued it is a necessary component in liability management. Presumably this implies several things: that profiled investors will never complain about their portfolios’ volatility because they have been tailored to match their personality; and that any potential claim from a disgruntled client can be defeated on the grounds that the portfolio was matched to their profile.
agree that investor risk profiles are useless. What strikes me is the fact that there are investments that are readily available to the public that are guaranteed by the FDIC yet not that many are taking advantage of them.
All investors have differing attitudes towards risk. When it comes to investing, it is important to consider your risk profile or tolerance carefully, including how comfortable you are with the possibility of losing money, or that returns on your investments could vary widely from year to year.
To establish an investment strategy that suits your profile of risk and will be comfortable with, you need to consider the possibility that the value of your investment may decline even though this may be temporary.
Even I Am Totally agree that risk analysis is based on individual Profile and Some investor risk profiles simply don’t work.
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all i can say is that before indulging into any investments, business should first calculate the risk that they are willing to give off. You should be honest enough to your self that even if you lose in that endeavor you will still be willing enough to give a competitive fight..