Risk tolerance is a very personal thing. It lies at the core of portfolio construction so it’s necessary for any adviser or investor, but attempts to measure it run into a number of challenges. Too often, though, these challenges are not fully addressed.
First, risk tolerance lies at the root of our psyches. And this is a very murky place. Many people never truly know themselves. Indeed, one of the lessons of behavioral economics is that people make irrational decisions often because of any number of inherent flaws in our thinking. In that vein, the idea of a client being able to pinpoint their risk tolerance sounds like a task for homo economicus (economic man) who makes every decision just right, rather than a real, flawed person.
I’ve written before on the pitfalls of behavioral economics, but risk tolerance is one place it can truly shine. Essentially a combination of economics and psychology, an understanding of behavioral economics is tailor made to help straighten irrational decisions when it comes to portfolio construction.
Rest assured, psychology is the harder of those two disciplines to master, but it’s the more important one for advisers when they’re trying to help clients determine how much money their portfolios can lose before they start blindly selling.
Indeed, some of those challenges in determining those risk profiles can be overcome with the proper survey. If constructed by a psychologist, the framing and sequence of the questions can help uncover someone’s true feelings. But a simple questionnaire won’t suffice, especially if it doesn’t lead to subsequent conversations through good markets and bad. For more on this, see our related story from Vanguard on risk management and dealing with clients.
What’s even more problematic is relying on other, broad brushstroke demographic surveys and assuming they can give you a good basis for client relationships. The ones that leave you with the idea that baby boomers feel one way, millennials another.
Those surveys often try to codify an entire generation, so responses can vary greatly. Indeed, anyone born from 1945 to 1964 is a boomer despite the fact that some came of age during the Eisenhower years, others during the Watergate scandal. If environment means anything, those are two very different influences.
Likewise, millennials are usually defined as anyone from 18 to 35 years of age, so some just graduated high school this year, while others are 10 years into their careers. They are in different places in their lives and their outlooks in life and investments are going to be vastly different. So depending on who exactly is surveyed, we can conclude that millennials live with their parents and have no money (as any 18-year old should), or we can worry that the “millennial millionaires” are getting overlooked. For more on millennials’ risk management, see our Q&A with Lipper’s Tom Roseen.
But we too often act as if these cohorts act as one: Generation Xers to this, millennials do that, boomers do something else.
I know it’s not new to say “people are different.” But it’s also not new to let an individual represent a pattern you already think you know. We’re hardwired to connect dots and look for patterns, and that can often help our understanding of a complex topic. But this is one case when you don’t want to be like Economic Man.