Advisor Perspectives welcomes guest contributions. The views presented here do not necessarily represent those of Advisor Perspectives.
Few issues are more important to investors than risk. A primal fear among investors is that they will run out of money in retirement and be forced to compromise their quality of life or even become homeless. One study found that nearly half of women in the United States who make more than $30,000 a year are afraid they will end up on the streets. Even more surprising, 27% of women with salaries of more than $200,000 expressed the same fear.
Fear of being homeless is so common it even has a name. It’s called peniaphobia.
To be a successful advisor, you need to understand how risk affects the decisions investors make and what you can do to make those decisions more objective and responsible. Demonstrating value at a time when investments are becoming more of a commodity is a popular topic in advisor-industry circles.
I can think of no greater value you can provide than bringing objectivity to this very emotional issue.
First, you need to understand what really drives risk tolerance decisions.
Loss aversion and risk tolerance
Studies have shown that the fear of losing money is the primary factor for how much risk an investor will tolerate.
This is an important finding for advisors. Previously, it was thought that changes in spending habits and consumer sentiment most impacted investor decisions about risk tolerance. However, if you accept the conclusion that loss aversion is the primary driver of risk tolerance, then you are confronted with a common dilemma. You understand more exposure to stocks will generate a higher expected return over the long term, but how do you deal with a prospect who tells you she cannot tolerate a meaningful drop in the value of her portfolio, even if it’s temporary?
The author of one such study, Michael Guillemette, an assistant professor at the University of Missouri’s College of Human Environmental Sciences and a certified financial planner, counsels advisors to reduce loss aversion anxiety by telling prospects and clients to view their returns less frequently (for example, annually instead of monthly).
Many advisors begin client meetings by reviewing portfolio performance. In bull markets, it’s tempting to do so because it’s easy to convey good news. However, this protocol may be counterproductive in bear markets. Guillemette believes the client will expect the same emphasis on returns when the portfolio is experiencing losses. Instead, he suggests focusing on “other value-added aspects of financial planning such as estate planning, insurance, taxes and long-term retirement goals.”
Recent experiences and risk tolerance
Studies have shown that an investor’s previous experiences impact the amount of risk he or she is willing to take. There is evidence that tolerance for risk increases when investors have reaped profits or are presented with the opportunity to compensate for earlier losses.
In a bull market, clients may be willing to take unacceptable risks because their portfolios have increased in value. Conversely, in bear markets, they may want to reactively decrease their level of risk. An increase or decrease in the value of an investor’s portfolio may, or may not, warrant a change in risk tolerance. It’s your job to help the client evaluate these factors.
Emotions and risk tolerance
The influence of emotions on risk tolerance has been well established. There’s a marked divergence in the risk-taking behavior of people with different levels of emotional intelligence. People with high emotional intelligence are able to focus only on the emotions directly related to the decision they are making. People with low emotional intelligence are influenced by emotions unrelated to those decisions. The co-author of one study, Stéphane Côté, gives this example: “People are driving and it’s frustrating. They get to work and the emotions they felt in their car influences what they do in their offices.” He adds: “Research has found that we fall prey to this all the time.”
You need to determine if a risk-taking decision is motivated by an unrelated emotion.
Bias and risk tolerance
One study found almost everyone is subject to bias. This finding was unrelated to intelligence, cognitive ability, decision-making ability, self-esteem, self-presentation or general personality traits. According to Carey Morewedge, an associate professor of marketing at Boston University, “People seem to have no idea how biased they are. Whether a good decision-maker or a bad one, everyone thinks that they are less biased than their peers.”
As an advisor, you don’t want your clients’ decisions about risk-taking to be the product of hidden biases. You need to flush out these biases and help them understand the role they play in their evaluation of risk.
Now that you are aware of the factors affecting risk tolerance decisions, consider them in discussions with your clients. You are uniquely qualified to bring perspective and objectivity to this important issue.
Dan Solin is the director of investor advocacy for the BAM Alliance and a wealth advisor with Buckingham. He is a New York Times best-selling author of the Smartest series of books. His latest book is The Smartest Sales Book You’ll Ever Read. He limits his sales coaching practice to advisory firms that advocate evidence-based investing.
Read more articles by Daniel Solin
Few issues are more important to investors than risk. A primal fear among investors is that they will run out of money in retirement and be forced to compromise their quality of life or even become homeless. One study found that nearly half of women in the United States who make more than $30,000 a year are afraid they will end up on the streets. Even more surprising, 27% of women with salaries of more than $200,000 expressed the same fear.
