Javelin Marketing Blog

Whenever you give investment recommendations, you assume an obligation to make sure that your selections are suitable for your clients. One factor that you probably consider is their tolerance for risk. How might clients react if their accounts lost 10%, 20%, or more? Would they understand that it was just a bump in the road to long-term growth, or would they fall into deep depression and put all of their money in a savings account, never to invest again? And what if the markets took a big upswing? Would they get caught up in the frenzy and make overly-speculative investments?

A client risk profile is a well-known tool designed to help financial advisors understand how clients feel about money. But can you rely on clients’ replies to tell you how their emotions will stand up to an extended bull or bear market? Is the computer-generated analysis of clients’ responses nothing more that a wobbly crutch for advisors who are looking for simple answers to a complex question?

Inaccurate Results

A psychological testing firm did a study of clients who had completed risk profiles. They concluded that the financial advisors’ estimates of their clients’ risk tolerance were accurate in less than half the cases; were slightly accurate in one out of three; and were significantly inaccurate in one out of six.

The researchers also found that the short form investor risk profiles  (like those offered by some financial institutions and the online guys) are generally unreliable and inaccurate, and they do not give a true picture of a client’s tolerance for risk and should be avoided.

Garbage In, Garbage Out

The risk profile questionnaires may ask clients to pick how much risk they would be willing to take to reach their goals. This is based on the foundation that clients will expect higher returns for taking greater risk. However, an investment strategy using this analogy may not be appropriate for all of your clients.

A study completed by Hersh Shefrin and Mario L. Belotti, Santa Clara University, concluded just the opposite. The two discovered that the observed investors actually expected higher returns from safer stocks than from riskier ones, even though they had stated otherwise. Would a risk profile questionnaire have caught this anomaly? It’s doubtful because clients’ risk tolerance level scores will only tell you what they perceive their comfort level to be at the very moment that they’re answering the questions.

Left Brain vs. Right Brain

Your clients have a dominate side of their brain that controls how they process information. Each side of the brain has its own unique and special abilities. The right side of the brain is spontaneous and acts on emotion, while the left side of the brain is logical and looks at facts and figures.

Clients complete the risk profile questionnaire in the comfort of their homes or in your office. Typically their left brain, which does the logical and analytical thinking, may cause them to answer rationally but possibly underestimate their ability to withstand bear market pain.

But what happens when emotions take over, such as during a severe market change? The right brain might become dominant and allow fears and dreams to override the left side’s ability to reason.  So even though they said on your risk profile questionnaire (which they may have completed in the middle of a bull market) that they would “buy more” if their portfolio fell 40%, they are now in your office freaking out, telling you to sell everything.  So much for the investor risk profile questionnaire.

Overconfidence=Overreaction

Investment selection is certainly important. Equally important is how your clients behave after they buy the securities. And investor behavior often is not rational—a characteristic than cannot be brought out in a risk profile questionnaire.

For instance, people typically have positive attitudes, thus they tend to underestimate the likelihood of a bad event. This built-in optimism may cause them to sell a stock that went up so that they can become more confident in their investment savvy. But at the same time, it could prevent them from dumping stocks that have little chance of recovery.

Which Investment Strategy is Best?

If you know that your clients may not always behave rationally, how can you come up with an investment portfolio that is suitable?

A do-it-yourself risk evaluation profile or an online version will take you out of the loop. And shouldn’t clients expect you to sit down with them face to face? If you’re just going to mail something to them or tell them to go online, why do they even need you?

It is often difficult for clients to verbally describe their attitudes about risk. This is because they may not know their financial selves, therefore they lack understanding on the financial risks that they are willing to assume. Maybe you need to look further than a one-size-fits-all form to comprehend clients’ reasons for investing.

Ask your clients about each investment they own. Why did they buy it? How do they feel about it now? How has it performed? Is it how they had expected? What would cause them to sell it? What’s the best investment they ever owned? The worst? Don’t be judgmental. Each of your clients is an individual and should be understood with his or her unique needs and attitudes in mind. Keep your poker face if a client tells you that he lost a bundle on a penny stock that his brother-in-law sold him. Uncover emotional ties, such as inherited stocks.

Have your clients’ attitudes about investing changed over the years? The outcomes of previous investment decisions, family changes, and age can influence how clients view risk compared to what they may have felt 10 or 20 years ago.

Ask your clients if they lose sleep during a drop in the market. Do they look at their quarterly statements, or do they leave them unopened and throw them in a drawer because even glancing at them would be too painful?

Work with your clients to develop a game plan that describes when they should sell a stock. Try to agree what circumstances might change this strategy. This may keep them from overacting to short-term events. And if they are tempted to override the plan, remind them of poor decisions that they might have made in the past. Let them know that you are only trying to prevent them from making the same mistake again.

Analyzing risks involves person-to-person communication and is not an exact science. But your in-person judgements of their emotional states will be far better than the static risk profile questionnaire. Those who want you to believe that you can identify a client’s true risk tolerance scientifically through a questionnaire are mistaken. Your clients are more likely to remain comfortable with an investment plan that fits their investment personality and emotional risk tolerance. And if you can expose those feeling with the right questions, and implement a suitable portfolio, your clients will stick with you through all kinds of market cycles.

Your clients react emotionally and will never be logical.

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