Greg B. Davies is a specialist in applied decision science, behavioural finance, and financial wellbeing – improving decisions through behavioural science. Here, he writes about the lack of understanding of risk profiling and the ways to avoid falling into the common pitfalls.
Risk profiling is essential to determining the right level of investment risk. Unfortunately, the profiling field is rife with misunderstanding and poorly designed assessment tools, leading many to view risk profiling as a regulatory box-ticking exercise, rather than a simple and effective way to improve investment outcomes.
Particularly problematic is the failure to distinguish between risk tolerance and other behavioural traits that affect in-the-moment attitudes to risk. At any point in time, the amount of risk someone is prepared to take is a mix of a) their cool, calm and collected willingness to trade off risk and return over the long term, and b) a whole bunch of momentary behavioural responses to their immediate context (often whatever it is they’ve just read in the newspaper). Thus, there is a crucial distinction between:
- risk tolerance, which reflects an investor’s stable, reasoned willingness to take risk in the long term; and
- behavioural traits, which represent the unstable, emotional willingness to take risk that is exhibited through an investor’s short-term actions.
It is only our stable, reasoned, long-term preferences that should be used to determine an investment selection suitable for a stable, reasoned and long-term investment journey. Behavioural responses are transient and context-dependent—not the kind of attitudes we want in the driver’s seat for our portfolio choices.
If profiling tools confuse risk tolerance with behavioural traits, we may find ourselves deliberately building portfolios that pander to ephemeral emotional responses. For example, it is frequently more comfortable to take risks when markets are high and pull back on risks when they’re low, but this doesn’t mean that buying high and selling low is good principle for portfolio design!
An investor’s actual in-the-moment choices are never purely reflective of risk tolerance—instead, such revealed-preference approaches result in a biased muddle of risk tolerance and context-dependent behavioural responses.
Instead, we should seek to mitigate and control these more destructive tendencies. Risk tolerance, measured correctly, defines the level of risk we should aim for; the other attitudes guide how we should manage ourselves over the journey.
Unfortunately, there is currently an ill-advised trend of using observed choices (or ‘revealed preferences’) to determine risk tolerance, whereby investors are presented with choices between portfolios or descriptions of investment outcomes, and risk preferences are inferred from the choices they make. Individual responses to such questions are highly unstable over time and should never be used to determine the absolute level of risk appropriate to an investor’s long-term total investment portfolio.
For example, consider a choice between:
- An expected return of 5%, with a maximum drop in any year of 15%; or
- An expected return of 8%, with a maximum drop in any year of 20%
Most investors simply do not know their preferences for future outcomes sufficiently to provide a robust response to this question, and any response is likely to be more an expression of their current perception of the economic environment than of their willingness to trade-off risk and return over the long-term. The result is a measure that is not only unstable, but which measures the wrong thing.
An investor’s actual in-the-moment choices are never purely reflective of risk tolerance—instead, such revealed-preference approaches result in a biased muddle of risk tolerance and context-dependent behavioural responses. A much-discussed example is loss aversion: an abundance of behavioural study tells us that humans dislike losses much more than they like gains. However, loss aversion is highly dependent on context, so it is very doubtful that it can measured as a stable feature of any single investor. And even if it could be, it doesn’t follow at all that one should want to plug a fleeting emotion into the design of a long-term investment portfolio. Instead we need to help investors control the anxiety that arises from this behavioural impulse. As a useful heuristic: if a risk-profiling tool claims to include a ‘measure’ of loss aversion for determining the right long-term risk level for an investor, give it a wide berth!
To be a good investor requires tools that cleanly separate one’s willingness to accept the range of a journey’s possible destinations, from the anxiety experienced along the journey. These tools should provide an opportunity for investors to learn about their attitudes, emotions, and biases; and in doing so, should help them prepare for the anxiety that is sure to arise from time to time. It should help investors mitigate and manage these behavioural attitudes, rather than pander to them. Risk profiling is not just for getting a better handle on the ‘right’ solution, it is also about helping investors with the emotional burden of actually investing in this solution—and sticking with it.
What investors really want is not the highest risk-adjusted returns, they simply want the best returns they can get relative to the stress, discomfort, and uncertainty they’re going to have to endure over the investment journey.
Controlling anxiety may require moving slightly away from the ‘best’ solution, if by doing so we purchase peace of mind efficiently and cheaply—that is, with as little deviation as possible from the solution that best fits an investor’s long-term risk profile. The right solution needs to be both efficient and comfortable. What investors really want is not the highest risk-adjusted returns, they simply want the best returns they can get relative to the stress, discomfort, and uncertainty they’re going to have to endure over the investment journey. In other words, they want maximum anxiety-adjusted returns.
A thoughtfully designed profiling process can cut through all this complexity, focusing on solutions that account for all three of these essential components: risk tolerance, behavioural traits, and risk capacity.
To advance, we should focus on developing dynamic models of risk capacity, and tools that truly help investors understand and articulate their own goals. We should concentrate much more on how we use the knowledge we obtain from profiling. And we should stop treating profiling as a point-in-time activity, but instead ensure that the suitability process adjusts dynamically to meet the constantly changing needs of investors.
For a full discussion of risk profiling, on which this article is based, see New Vistas in Risk Profiling.