Composure is essential to investing; changing strategy at the wrong time can have devastating effects on long-term investment returns. Measuring how a client is likely to react to volatile markets takes more than knowing them well.
While there are plenty of tools available to advisers, few bring science into the process, so it’s important to understand the essential elements that will provide the most effective outcome for each client.
Behavioural finance has become a bit of a buzz word but it does have a key part to play in getting an accurate feel for how clients are likely to react to the ups and downs of investing.
Analysing and comparing tools is time well spent for advisers who want to achieve a deep understanding of how they will need to manage clients, particularly during highly volatile periods.
Below are five important elements that combine to identify risk personalities:
1. Gain attraction
This measures an investor’s reaction to making investment gains and the degree to which an investor is hoping to outperform the average. This sometimes-overlooked principle is an important consideration to develop an overall understanding of what motivates an investor and how their investment portfolio should be constructed.
2. Loss aversion
This measures an investor’s reaction to making losses on an investment and is the basis for evaluating an investor’s overall risk personality type. Understanding an investor’s loss aversion goes a long way to help design an investment portfolio that will keep the investor composed during periods of high volatility.
3. The ‘S-Curve’
Investing involves uncertainty, which means that returns may often be higher or lower than what was expected. Investors tend to react differently to losses when compared with gains, where the 'unhappiness' caused by a loss is experienced more keenly than the 'happiness' resulting from a gain.
On average, the negative reaction to losses is roughly twice that of the positive reaction to gains (as shown by the dotted lines in the below diagram).
The ‘S-curve’ approach measures not only the investor’s attitudes towards actual and prospective changes in their wealth, but also explores risk seeking and risk avoiding behaviour.
4. Volatility anxiety
This measures the degree of discomfort an investor experiences as their level of wealth fluctuates, regardless of whether losses are actually realised. It will directly impact their level of comfort during an agreed long-term investment strategy. Anxiety levels often relate to shorter-term market fluctuations, the frequency with which these fluctuations are observed, and the likely consequences of disappointing returns on achieving investment goals.
Typically, higher levels of anxiety are closely associated with higher levels of aversion to losses (and vice versa).
5. Intervention risk
Intervention risk measures the likelihood that the investor will deviate from their agreed investment strategy. Intervention risk is not only triggered by falling markets, it can also be driven by overconfidence and optimism in times of rising markets and strong returns. This measure seeks to highlight the risk of actions resulting from ‘irrational exuberance’ or ‘unwarranted pessimism’, the net result of which may lead to a destructive ‘buy high, sell low’ syndrome.
Using a tool that covers all these elements is a good starting point, although how the questions are phrased in the assessment is as important to getting a robust outcome as ensuring key elements are included.
Something well worth looking at when it comes to the question set is how ESG/responsible investing is handled. It’s highly topical and there is new regulation coming, so understanding exactly what clients want and expect from their portfolios in relation to this is essential.
As many advisers experienced during March/April 2020, maintaining the composure of clients can be highly time-consuming. Putting the time in at the start of a client relationship to identify what sort of reactions they are likely to have to various scenarios can help advisers to segment clients and work out who will need the most hand-holding.
For more insight into the topic, check out this link to an article by the PortfolioMetrix global CEO, Brandon Zietsman.
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