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Falling Markets and Risk Tolerance

We think we know how much risk our clients can tolerate until they lose 40% of their wealth.

David J. Drucker, 06/25/2009

In my humble opinion, few people in our industry have studied a human's risk-taking behavior in greater depth than Geoff Davey, cofounder and developer of the FinaMetrica risk-profiling system out of Sydney, Australia.

With markets tumbling and clients scrambling to make sense of their diminished wealth, I asked Davey to expound on how to best assess and manage clients' revised expectations following such an event. Don't risk tolerances and plans based upon them fly out the window during times like these?

Drucker: Geoff, how does FinaMetrica work and do the scores advisors' clients racked up in more accommodative markets lose their meaning when we encounter a standout period like 2008-2009?

Davey: It's conventional wisdom that risk-tolerance collapses in bad times, but the evidence contradicts this. We've consolidated risk-tolerance data for four countries (Australia, New Zealand, the United States, and the United Kingdom) going back to May 1999 and found that investors' risk-tolerance score barely changed at all during the period 1999 through 2007, in spite of international markets' steep 2002 declines and 2007's steep run-ups. We've concluded that investors' risk tolerance is relatively unaffected by general economic mood.

Drucker: Clearly, though, investors act differently, that is, they seek more risk when markets are going up and they try to avoid risk when markets are falling. If this behavior can't be explained by changes in risk tolerance, then what?

Davey: Investing behavior is a function of more than just what we call "risk tolerance." There are four parts to it: 1) required risk, or that needed to produce the return the client needs to achieve his or her goals; 2) Perceived risk, or the risk perceived by the client in the course of action being considered; 3) Risk capacity, or the risk a client can afford to take given his need for wealth to satisfy his goals; and 4) Risk tolerance, or the risk normally chosen by the client. It would be difficult to argue that in 2007, before the current market crash, clients perceived equities as having low risk and that today they perceive them as entailing high risk. The risk of investing in equities hasn't changed, but the risk clients perceive has. If you swim in the ocean and it looks lovely but the next day you see a shark, that will change your perception of risk. It's therefore important for advisors to recognize how these four aspects of risk are distinct and to ensure there is no confusion between them when it comes to the client's decision-making.

Drucker: But the study period of 1999 to 2007 doesn't include today's market. If risk scores today are factored in, does the conclusion that risk tolerance is unaffected by the economy still apply?

Davey: Anecdotal evidence from FinaMetrica users shows no significant change in client risk tolerance in 2008. Hard data from January 2007 through December 2008, however, does show a decline, but only a very slight one--about three points--less than a third of a standard deviation.

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