Risk tolerance: Vita Palestrant

What is your financial personality?

We all know investing is meant to be a rational process. So to what extent can being aware of our biases and personality traits make us a better at it? Financial planners are increasingly turning to behavioural science and risk-profiling tools. Their aim is to identify your underlying motivations and help you become a more objective, rational and engaged investor. Risk-profiling tools range widely from sophisticated psychometric tests used by high-end financial advisers to basic questionnaires that combine a few risk-tolerance questions with your financial goals.

High or low risk

Risk tolerance is the degree to which you can stomach large swings in the sharemarket and variability in returns. An aggressive investor, or one with a high risk tolerance and is willing to risk losing money for potentially higher returns. A conservative investor with low risk tolerance prefers safe investments that preserve capital.

Campbell Heggen, a lecturer in financial planning at Deakin Business School, would like to see more emphasis on the cognitive sciences. “I’m of the view that behavioural coaching is a major part of the value a financial adviser can add. Risk profiling helps us identify potential negative behaviours and work through those as a sounding board.”

For instance, being impulsive and living in the moment can influence the ability of people to save or stick to a budget, he says. Others can be overly cautious. “They like to accumulate large bodies of information and consider all options before making a decision. It might mean you never take action, that you spend too long thinking about the positives and the negatives,” says Heggen.

Familiarity bias is another trait. “We tend to prefer investments we are more familiar with. To some extent that explains Australia’s love of real estate. We have the family home, we understand how the real estate market works so we are more comfortable with bricks and mortar investing than the sharemarket.”

Identifying these traits is important because financial planners have a legal obligation to “know” their clients and ensure their recommendations in their best interests.

Tools that help

Most advisers consider risk-tolerance tools as part of the process, rather than as a standalone solution, says Heggen: “If we look at a risk profile test or how it would typically work, the questionnaire would generally try to identify a number of traits which contribute to an individual’s overall risk profile.

“These may vary between questionnaires but the two main traits you typically seek to identify are the individual’s risk tolerance as well as their risk capacity.” He says risk

tolerance is the willingness of an individual to take on risk, whereas risk capacity is more about their financial ability to endure any loss.

The tests can range from simple questionnaires to psychometric tests. “There are variations in the tools being used. I’ve seen some basic tests that might have half a dozen or a dozen questions. They would be quite simple and perhaps not as comprehensive as most advisers would use. It might place investors into a number of different investor buckets from highly conservative, conservative to balanced, aggressive and highly aggressive. The terminology might vary but the principle is the same,” he says.

A good adviser, however, will try to go to a deeper level and “identify some of the uniqueness of the individual; their unique personal circumstances, their unique behavioural traits, their unique attitudes, their unique preferences, and refine the list of investment opportunities or strategies that may be appropriate.”

Heggen says some of the psychometric tests can reveal quite a lot about our personality. “It can be amazing how accurate they can be when you start to read through the profile.”

Nature and nurture

FinaMetrica’s risk-profiling system is regarded as world’s best practice and is used by financial planners in 23 countries. Paul Resnik, co-founder and director, explains that risk tolerance is a personality trait that rarely changes. “Risk tolerance tends not to change over time. It’s settled, generally, by early adulthood and it’s a mixture of nature and nurture. By the time you’re in your early 20s it’s probably settled for life,” he says.

But what does change is an individual’s risk perception and risk behaviour. “Risk perception is how people feel about the market at any particular time. And risk behaviour is what they do as a consequence.”

He cites the GFC as an example. “People were investing heavily into equities in 2007 and unwinding their equity portfolios in 2009-10. Now all of the sensible behaviour says that what they should have been doing was taking profits in 2007 and rebalancing their portfolios in 2009 and buying more equities at cheap prices.”

A good adviser, one you’ve learnt to trust and respect, could have been a stabilising influence and saved you from decimating your wealth. This is where a valid and reliable risk tolerance test is helpful for advisers, says Resnik. “If having done the test you discover someone has a low risk tolerance, but they are young and they have substantial ambitions to live well in retirement, you know you have a tension to resolve.”

One of the greatest issues the industry has is lack of trust because people are taken by surprise, he says. “We hide volatility, we don’t talk about uncertainty.

“You might say to this client, ‘Let’s start off with a portfolio that’s at the riskier end of your risk tolerance. Because markets are relatively unpredictable, they go up and they go down, let’s try and increase it over time.’ What we are trying to do is give you the confidence to stay [in it] when you have a larger amount in the market when it’s material to do so.

“What we are basically saying is the best return you will get is by having as much equity exposure as you can live with. If they have a low risk tolerance, they will likely panic and destroy value. So it’s better to have taken into account their risk tolerance than paternalistically saying, ‘I know what’s best: you should be fully exposed to equities.’

“What you are trying to build as an adviser is trust. Listening to your client, taking into account their risk tolerance, you need to frame their expectations: ‘It’s not largely consistent with your financial needs, you need to take more risk, but there’s nothing wrong with starting with the risk you are comfortable with.’ There should be no surprises in financial advice.”

FinaMetrica works with universities around the world and its intellectual property is international. “We did our original psychometric research with the University of NSW. We now work with the London School of Economics,” says Resnik.

Self-starter

Last year the Financial Planning Association launched a basic risk profile test for its Dare to Dream campaign. Ben Marshan, the FPA’s policy head and a certified financial planner, says it gives consumers some information about their financial personality type. (He got his mum to do it – see case study.) “It gives them a better understanding of their biases based on which of four risk categories they fall into and helps them understand how it might impact their financial future. We view it as fun quiz – it gives you a little insight into yourself and that will hopefully spark an interest in your financial position.

“You get people that think they are a lot more conservative than they actually are and need to be. And you get the other camp, people that think they are aggressive investors, but when they sit down and do the test they find they are more conservative than they thought they were.”

Marshan says a financial planner would go through a similar test. “That’s how they decide whether or not you are somebody who’s happy to take a lot of risk or someone who

wants to sleep comfortably at night knowing their money is safe.”

The other aspect is when you are going to need the money. “I might be a really aggressive investor but if I need the money in 12 months time, taking my normal level of risk – going all-out on the sharemarket – is way too much

risk based on the fact that I need the money in a year,” says Marshan. “Conversely, if I’m only comfortable with investing in term deposits but I need to invest for 30 to 40 years, I’m going end up in a much worse financial position than if I invested in the sharemarket.”

Before doing any risk-profile test, check its source to establish that it is reputable and trustworthy.