Risk tol­er­ance: Vita Palestrant

What is your fi­nan­cial per­son­al­ity?

Money Magazine Australia - - CONTENTS - VITA PALESTRANT

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.


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.

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