When Clients Mis­per­ceive Risk

Even if we have an ac­cu­rate mea­sure of in­vestors’ risk tol­er­ances, that doesn’t mean they won’t over­re­act to a painful de­cline in the mar­kets.

Financial Planning - - CONTENT - By Michael Kitces

Even if we have an ac­cu­rate mea­sure of risk tol­er­ances, in­vestors may still over­re­act to a painful mar­ket de­cline.

BE­FORE IN­VEST­ING CLIENT AS­SETS, AD­VI­SORS ARE re­quired to as­sess a client’s risk tol­er­ance. If an in­vestor takes on more risk than they can en­dure, they are likely to lose more money than they can stom­ach when the in­evitable bear mar­ket comes.

And even when the mar­kets re­cover, there’s a risk that the in­vestor will panic sell at the bot­tom.

Of course, if all in­vestors were as­tutely aware of their own risk tol­er­ance, the need to as­sess would be moot; clients could sim­ply self-reg­u­late their own port­fo­lio and be­hav­iors. The caveat, though, is that not all in­vestors are cog­nizant of — or may out­right mis­judge — their own com­fort level un­til it is too late.

ALIGN­ING PER­CEP­TION

We see the key prob­lem of in­vestors sell­ing at the bot­tom. In­vestors do not nec­es­sar­ily per­ceive the risks of a bull mar­ket be­cause it of­ten takes a bear mar­ket — or at least a se­vere cor­rec­tion — to align per­cep­tion with re­al­ity.

Some clients are es­pe­cially prone to mis­per­ceiv­ing risks (and thus tend to make fre­quently-ill-timed port­fo­lio changes). Or viewed an­other way, while some clients are quite good at main­tain­ing com­po­sure through mar­ket ups and downs, oth­ers have poor risk com­po­sure.

Un­der­stand­ing who prob­lem clients might be is not re­ally about as­sess­ing their risk tol­er­ance, per se, but try­ing to de­ter­mine their risk com­po­sure and the sta­bil­ity of their risk per­cep­tions.

RISK COM­PO­SURE

Un­for­tu­nately, at this point no tools ex­ist to mea­sure risk com­po­sure — be­yond rec­og­niz­ing that clients whose risk per­cep­tions vary wildly over time are likely to ex­pe­ri­ence chal­lenges stay­ing the course in the fu­ture.

Per­haps it’s time to broaden our un­der­stand­ing and assess­ment of risk com­po­sure be­cause, in the end, it’s the in­vestor’s abil­ity to con­sis­tently un­der­stand and cor­rectly per­ceive the risks they’re tak­ing that re­ally de­ter­mines whether they are able to ef­fec­tively stay the course.

COM­FORT ZONES

Con­ser­va­tive in­vestors of­ten don’t sell risky port­fo­lios un­til a per­ceived risk pushes them be­yond their com­fort zone, which is im­por­tant for two rea­sons.

First, it re­veals that the key is­sue isn’t gaps be­tween the in­vestor’s port­fo­lio and their risk tol­er­ance per se, but the gap be­tween the per­ceived risk of the in­vestor’s port­fo­lio and their risk tol­er­ance.

Sec­ond, it im­plies that even with ap­pro­pri­ate port­fo­lios, in­vestors could make bad in­vest­ment de­ci­sions if they mis­per­ceive the risk they’re tak­ing.

Imag­ine a client who is very con­ser­va­tive. It’s 1999, and he has watched from the side­lines as tech stocks have sky­rock­eted. Year after year, he has seen tech­nol­ogy eq­ui­ties beat cash and bonds like clock­work. The client grows con­vinced that there’s no risk to in­vest­ing in tech­nol­ogy stocks — they only ever go up. In this con­text, if you were a very

con­ser­va­tive bond in­vestor and be­came con­vinced that tech stocks were go­ing to beat bonds ev­ery year, what would you do? Why, you’d put all your money in tech stocks.

Once tech stocks do fi­nally crash the fol­low­ing year, how­ever, the con­ser­va­tive in­vestor will prob­a­bly sell and po­ten­tially lock in a sub­stan­tial loss.

TOL­ER­ANCE LEV­ELS

The key point here is that the in­vestor didn’t sud­denly be­come more tol­er­ant of risk in 1999, only to be­come in­tol­er­ant when the crash be­gan a year later. Rather, the in­vestor mis­per­ceived the risk in 1999 and then ad­justed his per­cep­tions to re­al­ity when the bear mar­ket showed up in 2000.

It’s the same pat­tern that played out with hous­ing in 2006. Or tulips in 1636. It’s not risk tol­er­ance that’s un­sta­ble, in other words, but risk mis­per­cep­tion.

Now imag­ine a client who is ex­tremely tol­er­ant of risk. She’s a suc­cess­ful se­rial en­tre­pre­neur who has re­peat­edly made cal­cu­lated bets and prof­ited from them. Ap­pro­pri­ate to her tol­er­ance, her port­fo­lio is in­vested 90% in eq­ui­ties.

But sud­denly, a ma­jor mar­ket event akin to the 2008 cri­sis oc­curs, and she be­comes con­vinced that the whole sys­tem is go­ing to break down.

As a highly risk-tol­er­ant in­vestor, what would the ap­pro­pri­ate ac­tion be if you were very tol­er­ant of risk, but con­vinced the mar­ket was go­ing to zero? You’d sell all your stocks — not be­cause you aren’t tol­er­ant of risk, but be­cause not even a risk-tol­er­ant in­vestor wants to own an in­vest­ment they’re con­vinced is go­ing to zero.

The key point again is that the in­vestor’s risk tol­er­ance isn’t nec­es­sar­ily chang­ing in bull and bear mar­kets. She re­mains highly tol­er­ant of risk. Rather, her per­cep­tions are chang­ing — and her mis­per­cep­tion that a bear mar­ket de­cline means stocks are go­ing to zero ac­tu­ally causes the prob­lem be­hav­ior. It con­se­quently leads the client to want to sell out of the port­fo­lio, even though it ac­tu­ally was aligned ap­pro­pri­ately to her risk tol­er­ance in the first place.

RASH DE­CI­SIONS

Ev­ery ex­pe­ri­enced ad­vi­sor is aware of a small sub­set of clients who are es­pe­cially prone to mak­ing rash in­vest­ment de­ci­sions.

They’re the ones who send emails ask­ing whether they should be buy­ing more stocks ev­ery time the mar­ket has a mul­ti­month bull mar­ket streak. And they’re the ones who call and want to sell stocks when­ever there’s a mar­ket pull­back and the scary head­lines hit CNBC and the news­pa­pers.

In other words, some clients have espe-

It of­ten takes a bear mar­ket to align an in­vestor’s per­cep­tion of risk with re­al­ity.

cially un­sta­ble per­cep­tions of risk. The cy­cles of fear and greed mean that most in­vestors swing back and forth in their views of risk at least to some de­gree.

BE­HAV­IORAL BI­ASES

But while the risk per­cep­tion of some clients swings like a slow metronome, for oth­ers it’s more like a seis­mo­graph.

It’s those lat­ter clients who seem to be es­pe­cially prone to the kinds of be­hav­ioral bi­ases that cause us to mis­per­ceive risk.

They are es­pe­cially im­pacted by the so­called re­cency bias, where we tend to ex­trap­o­late the near-term past into the in­def­i­nite fu­ture — i.e., what went up re­cently will go up for­ever, and what went down re­cently is go­ing all the way to zero. They may also be prone to con­fir­ma­tion bias, which leads us to se­lec­tively see and fo­cus on in­for­ma­tion that reaf­firms our ex­ist­ing — i.e., re­cency — bias.

OVER­CON­FI­DENCE

And for many, there’s also an over­con­fi­dence bias that leads us to think we will know what the out­come will be, and there­fore we will want to take ac­tion in the port­fo­lio to con­trol the re­sult.

In essence, some clients ap­pear to be far more likely to be in­flu­enced by var­i­ous be­hav­ioral bi­ases. Oth­ers are bet­ter at main­tain­ing their risk com­po­sure and not hav­ing their per­cep­tions con­stantly fluc­tu­ate with the lat­est news, nor be­com­ing flus­tered by ex­ter­nal events and stim­uli.

This is im­por­tant be­cause it means that clients with low-risk com­po­sure are ac­tu­ally most prone to ex­hibit prob­lem be­hav­iors re­gard­less of whether they’re con­ser­va­tive or ag­gres­sive in­vestors.

After all, an ag­gres­sive client with good risk com­po­sure may see a mar­ket de­cline as just a tem­po­rary set­back, while an ag­gres­sive client with bad risk com­po­sure may see a mar­ket de­cline and sud­denly ex­pect it’s just go­ing to keep de­clin­ing all the way to zero.

In each case, both clients are ag­gres­sive. The “right” port­fo­lio would con­se­quently be an ag­gres­sive one given their risk tol­er­ance, pre­sum­ing it aligns with their risk ca­pac­ity. But the client with bad risk com­po­sure will need ex­tra hand-hold­ing to stay the course, be­cause they are es­pe­cially prone to mis­per­ceiv­ing risk based on re­cent events, and think­ing the port­fo­lio is no longer ap­pro­pri­ate, even if it is.

Sim­i­larly, if two clients are very con­ser­va­tive but have dif­fer­ent risk com­po­sures, the one with high risk com­po­sure should be able to eas­ily stay the course with a con­ser­va­tive port­fo­lio and not chase re­turns, rec­og­niz­ing that even if the mar­ket is go­ing up now, it may well ex­pe­ri­ence mar­ket de­clines and volatility later.

Mean­while, the con­ser­va­tive client with bad risk com­po­sure is the one most likely to mis­per­ceive risk, lead­ing to re­turn chas­ing as they be­come con­vinced that a bull mar­ket in stocks must be a per­ma­nent phe­nom­e­non of guar­an­teed-higher-re­turns — only to come crash­ing back to re­al­ity when there is a de­cline in the mar­ket.

The key point here is that both con­ser­va­tive and ag­gres­sive clients can have chal­lenges stay­ing the course in bull and bear mar­kets even if their risk tol­er­ance re­mains sta­ble. Some peo­ple sim­ply have greater abil­ity to main­tain their cool through mar­ket cy­cles, while oth­ers do not.

And it’s those low-risk com­po­sure in­vestors who are more likely to mis­per­ceive risks — to the up­side or down­side — that tend to trig­ger po­ten­tially ill-timed buy­ing and sell­ing ac­tiv­ity.

CAN’T WE MEA­SURE?

If only we could fig­ure out how to ac­cu­rately mea­sure risk per­cep­tion and risk com­po­sure, we could iden­tify which in­vestors are most likely to ex­pe­ri­ence chal­lenges in stick­ing to their in­vest­ment plan.

Be­cause again, it’s not merely about the in­vestor’s risk tol­er­ance and whether they are con­ser­va­tive or ag­gres­sive with a prop­erly aligned port­fo­lio in the first place, but how likely they are to cor­rectly per­ceive the risks in the port­fo­lio.

This is also why it’s so cru­cial to start out with a psy­cho­me­t­ri­cally val­i­dated risk tol­er­ance assess­ment tool — though, un­for­tu­nately, few of to­day’s risk tol­er­ance ques­tion­naires are suited for the task.

Per­haps it’s time not only for a tool to mea­sure risk tol­er­ance, but also one that ei­ther mea­sures risk com­po­sure or at least pro­vides an on­go­ing mea­sure of risk per­cep­tion.

RISK TOL­ER­ANCE QUES­TION­NAIRE

Imag­ine two prospec­tive clients en­ter your of­fice. Both have ag­gres­sive port­fo­lios and say they’re very com­fort­able with the risks they’re tak­ing.

How do you know if the in­vestors are truly risk tol­er­ant, or if they’re ac­tu­ally con­ser­va­tive in­vestors who have mis­judged the risk in their port­fo­lios?

The an­swer: Give them both a high-qual­ity risk tol­er­ance ques­tion­naire and see if their port­fo­lios ac­tu­ally do align with their risk tol­er­ances.

If the risk tol­er­ance ques­tion­naire is com­pleted, and in­vestor A scores very ag­gres­sive while in­vestor B scores very con­ser­va­tive, it be­comes clear that in­vestor A is ac­cu­rately as­sess­ing risk and has the ap­pro­pri­ate port­fo­lio, while in­vestor B has be­come risk-blind and needs a dif­fer­ent port­fo­lio (not to men­tion an ed­u­ca­tion on how much risk they are ac­tu­ally tak­ing).

No­tably, though, while even this ap­proach can iden­tify clients who are mis­per­ceiv­ing risk, there is still no tool that di­rectly mea­sures risk com­po­sure or at least pro­vides an on­go­ing mea­sure of risk per­cep­tion (as by def­i­ni­tion, those with un­sta­ble risk per­cep­tion over time are the ones with poor risk com­po­sure).

For in­stance, clients might be reg­u­larly asked what their ex­pec­ta­tions are for mar­ket re­turns.

The ex­pected re­turn it­self — and es­pe­cially an in­ap­pro­pri­ately high or low re­turn — is an ex­press sign of risk mis­per­cep­tion, and those who ex­pected re­turns for stocks and bonds to fluc­tu­ate wildly over time would be scored as hav­ing low risk com­po­sure as well.

BIODATA AP­PROACH

Al­ter­na­tively, per­haps there is a way to ask clients more gen­eral ques­tions that as­sess on­go­ing risk per­cep­tions, or sim­ply as­sess risk com­po­sure up front.

This might in­clude a biodata ap­proach, ask­ing them whether his­tor­i­cally they’ve tended to make port­fo­lio ad­just­ments in bull and bear mar­kets — which at least would work for ex­pe­ri­enced in­vestors.

Other ques­tions might ask whether they like to take in cur­rent news and in­for­ma­tion to make port­fo­lio changes or try to mea­sure other sim­i­lar be­hav­ior pat­terns that sug­gest they are more ac­tively chang­ing risk per­cep­tions with new in­for­ma­tion and there­fore have low com­po­sure.

The bot­tom line is sim­ply to rec­og­nize and un­der­stand that in times of mar­ket volatility, what’s fluc­tu­at­ing is not risk tol­er­ance it­self but risk per­cep­tion, and more­over that risk tol­er­ance alone may ac­tu­ally be a poor in­di­ca­tor of who is likely to need hand -hold­ing in times of mar­ket volatility.

THE MISS­ING LINK

After all, if it was just about risk tol­er­ance, then any in­vestor whose port­fo­lio was in fact aligned with their tol­er­ance should be “fine” in stay­ing the course.

But in re­al­ity many clients aren’t, not be­cause their port­fo­lio is in­ap­pro­pri­ate for their tol­er­ance, but be­cause they mis­per­ceive the risk they’re tak­ing.

This causes them to ei­ther want to buy more (in a bull mar­ket that seems like a sure bet), or sell in a bear mar­ket (be­cause who wants to own an in­vest­ment you be­lieve is go­ing to zero, re­gard­less of your risk tol­er­ance).

Of course, a port­fo­lio that is not aligned to the in­vestor’s risk tol­er­ance will clearly be a prob­lem.

But the miss­ing link is that even for those with proper al­lo­ca­tions, those with low risk com­po­sure will still strug­gle with their in­vest­ment de­ci­sions and be­hav­iors.

And to the ex­tent we can fig­ure out how to iden­tify clients who risk per­cep­tions are mis­aligned with re­al­ity, and who have low risk com­po­sure and are prone to such mis­per­cep­tions, the bet­ter we can iden­tify who arel ac­tu­ally most likely to need help via a fi­nan­cial ad­vi­sor, or other in­ter­ven­tions to stay the course.

Rec­og­nize and un­der­stand that, in times of mar­ket volatility, what’s fluc­tu­at­ing is not risk tol­er­ance it­self but risk per­cep­tion.

Clients of­ten mis­judge their com­fort level around risk.

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