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Practice Management

It’s time to broaden our understanding—and assessment—of risk composure.

This Practice Management article is intended for financial advisors only (registered representatives of broker/dealers or associated persons of Registered Investment Advisors).

Before investing client assets, advisors are required to assess a client’s risk tolerance. If the 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 if the market recovers, there’s a risk that the investor will panic sell at the bottom of the market.

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.

Hence, we see the key problem of investors selling at the market bottom. Investors don’t 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.

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

But 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.

Misperceiving Risk
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’s seen tech equities beat cash and bonds like clockwork. The client grows convinced that there’s no risk to investing in tech 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 likely sell and potentially lock in a substantial loss.

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 collapse.

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.

Risk Composure
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 multi-month 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 especially 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. 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 so-called 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.

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 likely to recover, 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 the market declines.

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.

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 (RTQ), 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.

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 will likely need hand-holding in times of market volatility.

–by Michael Kitces
Michael Kitces, CFP, a Financial Planning contributing writer, is a partner and director of wealth management at Pinnacle Advisory Group in Columbia, Maryland; co-founder of the XY Planning Network; and publisher of the planning blog Nerd’s Eye View. Follow him on Twitter at @MichaelKitces.

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