Risk Profiling through a behavioural finance lens
Original article: https://www.cfainstitute.org/en/research/foundation/2016/risk-profiling-through-a-behavioral-finance-lens
As an improvement over the existing risk profiling techniques, factors such as lifetime financial experiences, past decisions and the peer group have a considerable influence on an investor’s risk profile.
Behavioural biases can be classified as cognitive (how we think) and emotional (how we feel). Cognitive biases can be further classified into belief perseverance and information-processing biases.
Belief perseverance: difficulty in modifying beliefs even when faced with compelling contrary information; related biases include cognitive dissonance, conservatism, confirmation, representativeness, illusion of control, and hindsight.
Information-processing biases relate to errors in processing information related to a financial decision. ‘Anchoring and adjustment’ is an example. Related biases include mental accounting, framing, availability, self-attribution, outcome, recency.
Emotional biases include loss aversion, overconfidence, self-control, status quo, endowment, regret aversion, and affinity.
It is difficult to change the emotions of the clients. Hence, advisors must focus on modifying clients’ thinking – that is, moderating their<behaviours.
Your advice must be based on the level of wealth and the intensity of biases of your clients.
Both the advisor and the client need to agree on what they mean by risk. Risk appetite and risk capacity can be ascertained but clarity on how much known and unknown risks that a client can take is also essential.
Known risk can be understood easily and quantified using historical data from observation of financial markets. Unknown risks are abnormal risks that fall outside expectations. If known risks are one to two standard deviations from the normal, unknown risks can be said to be three to four standard deviations from the normal. It is probably best to call the sub-prime crises of 2008 as an event of unknown risk.
Unknown risks carry the potential for behavioural problems in the investment process.
Risk tolerance and behavioural finance
Understanding a client’s risk tolerance can help in narrowing down the client’s behaviour investment type. This can mitigate client behavioural surprises that might otherwise dispose a client to change their portfolio as a result of market turmoil. If an advisor can use this to reduce the number of traumatic episodes for the client, a stronger client relationship can be built.
The least risktolerant investors and the most risk-tolerant investors are driven by emotional biases, whereas the two types in between these two extremes are mainly affected by cognitive biases.
With aggressive clients, the best approach is to deal with their biases head-on and discuss how their investment decisions will affect such emotional issues as family members, their legacy, and their standard of living.
Emotional investors are to be explained issues such as financial security, retirement and the impact on the future generations. A quantitative approach is more effective with clients who are less emotional and tend to make cognitive errors.
- Preserver / Conservative: They are risk averse and may fuss over short term performance. Investors who have inherited their wealth or have built a fortune by not risking their capital (by working in large companies) are generally conservative. Endowment bias, loss aversion, anchoring and adjustment, mental accounting, status quo are some biases harboured by conservatives.
- Loss aversion bias: (Emotional) They feel the pain of losses more than the pleasure of gains, they stick to loss making investments with the hope of a turnaround
- Status quo: (Emotional) They prefer to keep things the way they always have been; that is their mental comfort
- Endowment bias: (Emotional) They assign more value to an owned asset, say real estate, than they themselves would actually pay to acquire that asset
- Anchoring and Adjustment
- Mental Accounting
Advice for conservative investors (CI): CIs need ‘big-picture’ advice, and advisers should not dwell on such details as standard deviations and Sharpe ratios or else they will lose the client’s attention. After a while, CIs are likely to become an adviser’s best clients because they value greatly the adviser’s professionalism, expertise, and objectivity in helping make the right investment decisions.
- Followers / Moderate Investors: They lack their own ideas about investing and follow a friend or a colleague’s ideas. They often over-estimate their risk tolerance. They sometimes do not enjoy, or do not have the aptitude for, an investment process. Some biases exhibited are:
- Recency: (Cognitive) More emphasis on recent events, or noises
- Hindsight: (Cognitive) The investor perceives past investment outcomes as if they had been predictable.
- Framing: (Cognitive) This is the tendency of investors to respond to situations differently on the basis of the context in which a choice is presented (framed). (Such investors will have different answers to thetwo similar questions ‘how risky is your investment’ and ‘how safe is your investment’?
- Cognitive dissonance: (Cognitive) These investors try to alleviate their discomfort by ignoring the truth and/or rationalizing their decisions. They will continue to invest in an underperforming security even when they should be judging the subsequent investments independently and objectively.
- Regret Aversion: (Emotional) They believe that whatever decision they take, it will be proved unwise.Advice for Moderate Investors (MI): Because MI biases are mainly cognitive, educating MI clients on the benefits of portfolio diversification and sticking to a long-term plan is usually the best course of action. Advisers should challenge MI clients to be introspective and should provide data-backed substantiation for their recommendations.
- Independent / Growth Investors (GI): GIs are often self-assured and “trust their gut” when making decisions; when they do their own research, however, they may not be thorough enough with due diligence tasks. GIs sometimes make investments without consulting anyone. GIs may resist following an investment plan. Their characteristics give rise to the following biases:
- Conservatism: (Cognitive) Sticking to the prior view at the expense of acknowledging new information.
- Availability: (Cognitive) They tend to choose from the alternatives that appear in front of them and fail to look for the hidden or unadvertised ones. They are more likely to perform a Google search for top mutual funds or shares instead of doing a thorough research.
- Representativeness bias: (Cognitive) They pick one unit from the sample, understand the unit’s characteristics and believe that the entire sample will exhibit the same characteristics.
- Self-attribution (self-enhancing) bias: (Cognitive) They take credit for gains and blame externalities for losses
- Confirmation bias: (Cognitive): They give importance to people or evidence that proves their idea correct and ignore the rest
Advice for Growth Investors (GI): A good approach is to have regular educational discussions during client meetings, in which the adviser does not point out unique or recent failures but, rather, educates clients and incorporates concepts that are appropriate for them. GIs are independent minded but are grounded to listen to sound advice.
- Accumulator / Aggressive Investors (AI): These entrepreneurial clients are often the first generation in their family to create wealth. AIs are overconfident. They believe they can control the outcome of their investments by readjusting and rebalancing their portfolio upon every market movement.
- Over-confidence: (Emotional, with cognitive aspects) They have unwarranted faith in their thoughts and abilities
- Self-control: (Emotional) They have the tendency to consume today at the expense of saving for tomorrowalong with their tendency of taking higher risks. They believe they will continue to be in control
- Affinity: (Emotional) They irrationally make uneconomical choices on the basis of how they believe a certain investment will perform
- Outcome: (Cognitive) Outcome is more important for these clients than the process.
- Illusion of control: (Cognitive) They believe they can influence the outcome much more they really can.
- Advice for Aggressive Clients: Firming up a strong IPS is a pre-requisite for engaging with such clients. Advisers need to prove to the client that they can make great, objective, long-term decisions and that they can effectively communicate the results.
When viewing risk tolerance from a behaviouralfinance perspective, advisors must try to identify how their clients will react not only to known risks but also to unknown risks.
Also, it is essential to distinguish between the various types of biases. Advice should be tailored according to the level of emotional and cognitive biases that a client exhibits.