1 year ago

Blue Chip Issue 81

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Blue Chip is a quarterly journal for the financial planning industry and is the official publication of the Financial Planning Institute of Southern Africa NPC (FPI), effective from the January 2020 edition. Blue Chip publishes contributions from FPI and other leading industry figures, covering all aspects of the financial planning industry. Blue Chip takes this opportunity to wish the FPI a happy 40th anniversary. Congratulations!


RISK TOLERANCE The perils of risk tolerance questionnaires Where you (the financial planner) can bridge the gap Understanding your client’s capacity for risk is key to advising them on a sound investment strategy. Failure to do this correctly may result in an excessively risky portfolio requiring more frequent rebalancing, or too conservative a portfolio which doesn’t achieve the client’s investment objectives. There are a variety of methods to assess risk tolerance, but questionnaires remain the simplest and most common. Because of that, they need to be psychometrically sound. They need to assess cognitive (thinking) and affective (emotional) elements, and they also need to be valid, reliable and consistent. This last point is something that piqued my interest a while back. Risk tolerance differs from one individual to another and is a function of socio-economic and other personal factors. Thus, surely a risk tolerance outcome should be unique to the individual, not dependent on the type of assessment tool? So, my team did a little study. We sourced several risk tolerance questionnaires and created four hypothetical individuals: we needed someone who was very risk-averse and another person who was very risk-tolerant, and two others somewhere in between. To do this, we assigned different characteristics to these individuals that are predictive of risk tolerance, such as level of financial literacy and age (to name a few). Then, we completed each questionnaire four times – once for each individual. We wanted to see whether the results were in line with the expected outcome for each of the individuals and whether they were consistent among the different questionnaires. The results were as follows: 86

RISK TOLERANCE You would expect the individual to get the outcome that matches their colour, ie the the low-risk tolerant individual (top row) should get all (or mostly) dark blue outcomes. But we don’t see the colours matching. Our low-to-medium risk tolerant individual (second row) had a high-risk tolerance outcome (turquoise). And our high-risk tolerant individual (bottom row) only had 25% of its outcomes matching that risk tolerance. The questionnaires tended to underweight a person’s risk tolerance. And there was no consistency. We also picked up some other problems in the questionnaires: a lot of redundancy and self-assessment. Self-assessments are not ideal. No-one knows how they are going to feel about losing money – until they lose money! Furthermore, there weren’t any questions that assessed personality type or financial literacy. Pause for a second here – think about the questionnaires or tools you are using. Do you think they are appropriate? Are they getting it right? Think critically about what you are trying to assess and why. Risk tolerance questionnaires are flawed. Thus, there is a vital role to be played by the financial planner. To do that, you need to read your client’s behaviour, ask the right questions, and manage your own biases. And while we are talking about risk tolerance, that doesn’t necessarily mean it should be the starting point. Let me explain. If you start with assessing risk tolerance, the next natural step is to advise an asset allocation based on that. That asset allocation will then determine the client's return, which dictates their lifestyle. Let’s switch that around. What lifestyle does your client want? What returns do they need to earn to live that lifestyle? What assets do they need to invest in to earn those returns? And finally, what associated risk is then required? surgery, you will push through the pain. Likewise, risk is inevitable. You need to tolerate it to achieve the returns you want. This speaks to client education. Running the numbers on what returns are needed is the easy part. Your value-add to your client is relational. 3. Don’t give them too many options. As humans, we struggle with information overload. And when that information is difficult to understand, it is even more perilous. Value your expertise! Believe in your ability to advise appropriately. You know the answer… but your role is to manage your client’s behaviour and mindset… and that will only come with time (if you are understanding them properly). But it is well worth the investment. Make sure you are speaking about risk from the client’s perspective. This is where it starts to get interesting. If your client’s risk tolerance matches the risk that is required – there is no problem. But if that is not the case, how do you manage that misalignment? Here are some key things to consider in your client interactions: 1. How do they define risk? I am generalising, but in most instances, when I talk to someone about risk, they immediately say things like, “I can’t afford to lose my money.” That is not risk aversion, right? That is loss aversion. It is different. It speaks to the client’s capacity to handle a loss. Make sure you are speaking about risk from the client’s perspective. Use terms and examples that they understand. 2. Do they realise that risk is inevitable? If you ask someone if they want to experience pain after surgery, they will obviously say, “No.” But pain is inevitable. If you need the Dr Gizelle Willows is an Associate Professor at the University of Cape Town and Managing Director of Nudging Financial Behaviour 87

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