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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.

Drucker: What if a client's retirement savings were so diminished by current events that they can no longer afford to retire? Doesn't a life event like that cause a change in risk tolerance?

Davey: We have underway a major research project that surveys advisors and their clients about their reaction to the global financial crisis. Seventy-one percent of study respondents perceive equity markets to be anywhere from somewhat- to considerably-more-risky than in 2007. But we believe risk capacity has as much to do with this as anything else. If a client's losses are so severe as to have compromised their risk capacity--the amount they can afford to lose before their losses jeopardize their financial goals--then that can affect behavioral change.

Drucker: I believe people misunderstand the concept of risk tolerance versus the concept of risk capacity.

Davey: A better name is probably "risk preference," where an individual hits a balance point between risk-seeking and risk-avoiding. Most people are prepared to take some risk, but the degree varies from individual to individual. We see clients who are unhappy they've been exposed to too much risk and suffered a steep downside, but, at the same time, clients exposed to too little risk feel that they've missed opportunities. We actually had a court case here in Australia four or five years ago where an investor sued his broker for not giving him enough risk [during a market upswing].

Drucker: So what was your final study conclusion?

Davey: Investors' risk tolerance appears stable, and changes in behavior cannot be attributed to changes in risk tolerance. Rather, changes appear to arise from changes in risk perception and capacity.

Drucker: How about the many advisors who use FinaMetrica's risk profiling system ... are they finding that it's helped or hurt them?

Davey: We haven't had any negative comments at all during the market downturn. I think people are normally quicker to complain than praise, so we feel good about this. One of our advisors even said, " 'The adoption of FinaMetrica risk-tolerance assessments has been one of the best things we have done in the last 20 years.' Our clients are reacting to the current downturn in exactly the way that we would hope, i.e. 'I'm not happy that my investments have dropped in value by x%, but you did tell me it could happen.' "

Drucker: The FinaMetrica system only measures risk tolerance and, yet, there are three other components of risk.

Davey: Our system measure tolerance because, of the four risk variables, it's the most difficult to get a handle on. Most advisors using their own risk-tolerance questionnaires don't get meaningful, useful results--though they may think they do. Fortunately there is a scientific discipline--psychometrics--for testing attributes such as risk tolerance. Psychometrics, a blend of psychology and statistics, provides a discipline for developing a valid and reliable test, and standards against which to evaluate risk tolerance. In psychometric terms, a valid test is one that measures what it purports to measure, and a reliable test measures consistently with known accuracy. Unfortunately, advisors and the financial-services industry have had little, if any, exposure to psychometrics and are largely unaware of its benefits.

Drucker: In the end, how does our understanding of the client's risk tolerance lead to a portfolio recommendation and acceptance by the client that the portfolio we give him satisfies all four risk components?

Davey: If we can't arrive at one asset allocation strategy for the client that satisfies all four risk components, then the client's financial plan must seek to reconcile those components, which might happen by 1) increasing his resources by having the client earn more and/or spend less; 2) converting personal use assets to investment assets, 3) delaying, reducing and/or discarding lower-priority client goals, and 4) by taking somewhat more risk than would be the client's preference, but not to the point where, in a downturn, they might panic and sell.

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