Have you ever had a client who unexpectedly loses their nerve amid jittery markets? It’s not uncommon to see clients whose risk tolerance suggests they should be able to withstand the fluctuation in their portfolio react with a much more conservative risk tolerance. Has your risk tolerance questionnaire failed?
The culprit may not be your clients’ risk tolerance at all but rather their risk perception. Risk tolerance is an enduring psychological trait that reflects how we feel emotionally about taking risks. Risk tolerance does not tend to change, even as we transition through life stages and market cycles. Risk perception, on the other hand, is our cognitive appraisal of a given risk. Whereas risk tolerance guides how we respond to risk, risk perception determines how risky we find something in the first place. Unlike risk tolerance, risk perception can be quite fickle.
Advisers are no strangers to handling risk tolerance; good financial planning is built on balancing a client’s risk tolerance with their capacity and needs. However, advisers also need to learn how to manage their clients’ perception of risk to keep them on track. Left unchecked, poorly calibrated risk perception may lead to suboptimal behaviors both in good times (chasing returns) and bad (panic selling).
Risk perception can be challenging to manage, as it’s influenced by many external and internal factors (even cloudy weather!). Nonetheless, advisers can help clients better evaluate risk by building a solid foundation based on context, expectations, and confidence.
Defuse the Unknown by Putting Risk Into Context
It’s natural to fear the unknown, as we tend to fill in gaps in our knowledge with worst-case scenarios, making us believe something to be riskier than it is. For many everyday investors, one of the biggest determinants of how risky they perceive an investment is how familiar they are with the product in the first place. However, market volatility may affect clients’ perception of risk regardless of their familiarity with their investments. As market volatility is inherently unpredictable, it can foster feelings of dread over losing money, which can lead clients to evaluate an investment as riskier than they typically would.
Though advisers cannot control market volatility, they can educate their clients on their investments to defuse the fear of the unknown. Educating clients means not only ensuring they understand how various investment vehicles work but also what volatility means for them. Clients’ plans are built with their goals and accepted risk strategies in mind. Therefore, advisers can help clients contextualize any proposed actions in response to uncertainty by evaluating them from the standpoint of “Is this consistent with the plan we’ve agreed to?” This context can help clients anchor back on their goals, stick with their commitments, and feel confident that their plan is tailored to get them where they want to be.
Although clients can recalibrate their risk perception amid volatility, it is best to prepare them beforehand. If your clients often react adversely to market volatility, they are likely surprised. This means their expectations for what risk should look like do not align with their reality.
You can minimize risk misalignment during uncertain times by building a solid understanding of investment risk from the get-go. Clients will particularly benefit from understanding the relationship between risk and return and the range and likelihood of possible outcomes (including the possibility of extreme events). Start with a robust, stable risk tolerance measure to determine how much risk your clients are comfortable taking and are willing to accept in pursuit of their goals, while attending to their risk capacity. Then, illustrate, explore, and test the reasonableness of clients’ expectations against historical performance to identify gaps. Check in periodically with clients to manage creeping expectations and further consolidate understanding.
Risk perception can be affected by the knowledge, context, and expectations your clients have, especially when markets are in turmoil. Advisers are well-placed to arm clients with the framework they need to appropriately evaluate risk.
Improve Risk Calibration by Building and Managing Confidence
Education is the first step to helping clients better evaluate risk, but confidence also plays an important role in our judgment of risk. Clients who have confidence in their plan, their adviser, and their own knowledge will be better able to manage their risk perception. As outlined above, education helps build trust in an adviser’s expertise, making clients confident they can rely on their adviser’s guidance. Just as advisers benefit from continuing professional development, clients can fine-tune their risk assessments and improve their confidence through continued structured learning, guidance, and support.
However, advisers must also help clients recognize when overconfidence may lead their risk perception astray. In particular, cognitive biases may make us feel more confident in our conclusions than warranted. For example, a common mental shortcut is the availability heuristic, where we draw conclusions based on familiar or readily available information. That can be helpful but can also inflate our confidence. When headlines, influencers, friends, and family are feeding us the same message, we tend to forget or ignore contradictory information.
Clients may rely on numerous shortcuts when forming judgments, and advisers cannot expect to identify and provide guidance on every occasion. Instead, advisers can help their clients craft a set of decision rules they can rely on when making risk judgments to help combat overconfidence that may come from mental shortcuts. For example:
- Is this information from a reliable source?
- Is it supported by objective evidence?
- Are there counterarguments? What are they?
- Am I in the right emotional state to make decisions?
- What is the likely impact on my strategy and goals?
The objective is to equip clients with tools and processes to readily make informed judgments and recognize when bias may be at play. This will help clients combat the false confidence that cognitive biases can bring and help them come back to the fundamentals of their education, where true confidence should live.
Market sentiment can affect your clients’ perception of risk in their portfolio; in turn, this can make them want to make changes to their investment strategy. But investment strategy changes should be driven by changes in things such as goals and circumstances, not market sentiment. When clients’ risk perceptions are miscalibrated, advisers should provide them with the education and confidence they need to realign their perceptions with reality. Managing clients’ knowledge, expectations, and confidence sets them up to make informed risk choices.
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