Conflicting Attitudes to Risk

By a twist of fate, I found myself involved in a fascinating debate on attitude to risk at a Financial Marketing Club dinner. We had been due to hear about IHT planning from an industry veteran but he was way-laid and, at no-minutes-notice, Newcastle University student Jessica Fox bravely stepped in to talk about psychology and investing, a subject in which she has conducted original research with investment advisers for her dissertation.

It is tempting to blog about Jessica’s attitude to risk in choosing to fill in in front of experienced financial advisers and providers: clearly, she saw it as an opportunity and in so doing neatly dispelled simplistic assumptions about male and female traits. However, Jessica had a twist of her own to focus on. Her research looked at the difference in attitude to risk (tolerance, not capacity) of advisers compared to their clients and how it has varied through the financial crisis. The results of her research are not altogether surprising but the implications of it are challenging indeed.

You can read a summary of the results in Jessica’s own words in a guest blog here. My own briefer, less eloquent summary is that advisers typically had a significantly greater acceptance of risk than clients and were far less prone to change their attitude in response to market gyrations. Clients, by contrast, are highly inclined to buy high, sell low in practice.

This throws up some knotty questions to which I rather doubt we have definitive answers. If you hate open questions and blogs that present no simple conclusion, I’m going to infuriate you.

  • Do you put yourself through the ATR questionnaires you use with your clients?
  • Do you periodically re-take the questionnaire to see how your own ATR is changing (or not)?
  • Is it easier to advise clients with a similar ATR as you?
  • How do you prevent the difference between your ATR and a client’s influencing your advice?
  • How do you respond to changes in a client’s ATR when there has been no material change in their circumstances, only in their sentiment?

In our roundtable discussion, various people cited examples of very poor questions in certain ATR tools. While these were lamentable, having a consistent and thorough process and well-designed questions is surely a good thing. But how much should we expect tools like ATR do? Whether now or in future, do we see technology and science handling even the psychological elements of investing and tackling the issues above?

Having alluded to the strong influence of sentiment on markets, I’ll leave you with a final thought:

  • Will we ever see a fund whose investment strategy is purely driven by an algorithm that quantifies / predicts the dominant mentality of the herd?

3 thoughts on “Conflicting Attitudes to Risk

  • FinaMetrica’s research is largely consistent with Jessica Fox’s conclusions. Financial advisers are in general more risk tolerant than their clients. Higher risk tolerance is often associated with over confidence. This means that advisers need to be cautious about providing straight out investment recommendations for instance, rather than working toward a collaborative decision with the client in relation to the likely risks and returns in say two portfolios. A client’s informed consent to accept the risks in their portfolio is likely to lead to it being held for the longer term. Over time it should give a better return than a portfolio thrust upon the client because it matches what the adviser sees as the clients needs, particularly if the adviser recommendation is riskier than what the client would have have chosen for themselves. Such a portfolio is more likely to be at least partly liquidated when markets turn sour.

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  • The industry does seem to emphasise the ATR questionnaire rather more than the risk discussion which is supposed to follow it. Many ATRs I’ve seen carry arguably irrelevant questions (e.g. “How long do you expect to hold on to this investment” ) which should be part of the discussion rather than contributing to the score. Calibration is often spurious, e.g. where the score allocated cannot affect the result. Worse, there is a general lack of behavioural economics being applied to these questionnaires – Prospect Theory has a number of excellent examples of how posing the same question in a different framework can lead to a different answer. I suspect a number of well used ATRs have more input from product teams than from behavioural psychologists- there are a number of tests of risk aversion in the psychology literature that will never get within a light-year of a marketing department.

    Finally, the whole process is built on a shaky foundation because the risk score is generally (I don’t include Finametrica here) directly calibrated with an asset allocation. That allocation calculation will have been built using an expected volatility number, i.e. standard deviation of returns. Well, I don’t know about you but I actually quite like volatility on the upside, i.e. the performance spikes above the mean return. We should all like that because they are positive by definition. The only volatility we should care about is downside volatility, i.e. returns below the mean. There is a measure for this – semi-deviation. Markowitz, the father of Modern Portfolio Theory, wanted to use this calculation in the 1950s but the lack of computing power meant the calculations were too long-winded. It can be done now of course on a relatively simple spreadsheet. You will not find an asset allocation from a provider that uses this. Relative risks assume fixed income is constantly less risky than equity. It isn’t – it rises over the first few years but then falls away again towards maturity. This is often not accounted for.

    In short, I’m increasingly persuaded that the risk discussion, in depth and with supporting (simple) collateral the client can reference, is more important than the ATR – a largely clerical exercise. The asset allocation needs to be more qualitative, more diligently monitored along the way, and built initially with the right numbers but as a starting point for a discussion with the client who wants to have some involvement in the process.


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