Understand Client Actions and Expectations with Risk Assessment Tools

Journal of Financial Planning: December 2019​​

 

 

Chris Heye, Ph.D., is founder and CEO of Cogniscient, and co-founder of the age-focused financial planning software platform Wh​ealthcare Planning. He serves on FPA’s FinTech Advisory Group.

One of the most important current trends shaping the advice offered by wealth management professionals has been the adoption of practices grounded in behavioral economics. While insights from behavioral economics have been around for decades, only recently has the research conducted by scholars such as Daniel Kahneman, Richard Thaler, and Robert Schiller been utilized by advisers to understand and manage the actions and expectations of clients.

Perhaps the most important reason for the delay in adopting behavioral approaches has been the difficulty in translating research findings into rigorous and quantifiable client recommendations. Unlike modern portfolio theory or the capital asset pricing model, concepts such as bias, framing, anchoring, overconfidence, “rules of thumb,” and regret are not easy to model using a spreadsheet or even sophisticated computer algorithms. And making these concepts easy for a client to understand without coming across as a pop psychologist poses its own set of challenges.

Like in many other areas of the advice profession, however, technology has come to the rescue. Many fintech companies are currently seeking to incorporate behavioral economic findings into their offerings for financial advisers.

The influence of behavioral economics is most notably evident in risk tolerance measurement technologies. Risk tolerance tools are designed to measure a client’s attitudes toward financial risk, including their willingness to trade-off (large) potential gains for (large) potential losses, and in some cases also assess the degree of consistency in financial decision-making.

Putting Prospect Theory into Action

Riskalyze has been the leading pioneer in the field of risk tolerance measurement technologies. Its short risk tolerance questionnaire is grounded in Daniel Kahneman and Amos Tversky’s research on “prospect theory,” which found that for most people, the pain of losing a specific amount of money is greater than the pleasure of winning the same amount.1

After a client completes a Riskalyze questionnaire, the application generates a summary risk score from 1 to 100. When the client’s financial holdings are entered, the application has the ability to generate a score for the client’s current portfolio. It can then compare the two scores, showing the client (or prospect) how closely the risk in their portfolio matches their risk tolerance level.

The result is a simple, yet powerful, attempt to align the composition of investment portfolios with personality traits. Recent additions to Riskalyze’s core risk assessment tools include automated rebalancing and trading services (integrated with major custodial platforms), marketing support capabilities, and even some retirement planning features. Advisers looking for a turnkey solution with risk tolerance, trading, rebalancing, and planning functionality might be well served to take a close look at Riskalyze.

Beyond Risk Tolerance

Even if you are skeptical about the ability of a short questionnaire to accurately assess a client’s “true” level of risk tolerance, there are still good reasons to use risk assessment tools with your clients:

Initiate conversations. Using a risk assessment questionnaire can be a good way to get to know your client. It can lead to a better understanding of their fears, goals, and decision-making style.

Justify actions. Risk assessment tools can help you justify trades and other activities that you take on behalf of your client. Assuming you are making trades to bring a client’s portfolio into alignment with their stated risk tolerance preferences, you have a way to explain to clients what you did and why.

Recruit new clients. Showing a prospect that the risk level of their portfolio is out of sync with their stated level of risk tolerance can be a powerful way for you to highlight the value that you can add while helping to differentiate your services.

Not a Perfect Solution

Risk tolerance questionnaires have attracted critics as well. Here are some of the most common criticisms:

A client’s “true” risk tolerance level cannot be captured in traditional risk questionnaires. This is not just because people lie when answering questions—though some do. Many investors are incapable of predicting accurately how they will respond to unfamiliar events in the future. And for many of us, our “stated” preferences for risk diverge from the “revealed” behaviors we show in everyday life (more on this below).

A client’s risk preferences may change over time. There is no reason to assume that a client’s tolerance for risk will remain constant over time. In fact, we would expect it to change as their income, wealth, and life goals evolve. As the capacity to take on risk shifts with changes in wealth, risk tolerance levels could change as well.

Dementia or other forms of diminished capacity render risk assessment results moot. Risk tolerance questionnaires are at best useless, and at worse dangerous, to use with any client with serious cognitive or behavioral issues.

Options Abound

Spurred by the success of Riskalyze and by the perceived shortcomings in that approach, other tech providers are now offering their own risk assessment tools.

TrueProfile, for example, offers an application for advisers that is designed to uncover a client’s “revealed” level of risk tolerance rather than his or her “stated” preferences. Their approach is also grounded in rigorous academic research, including economist Paul Samuelson’s work on decision-making theory and revealed preferences.2Their founder, Berkeley economics professor Shachar Kariv, has worked extensively in the field of risk measurement and tolerance and has been published in numerous prestigious scholarly journals.

Using a 90-second risk simulation tool, their application measures not only risk tolerance levels, but also a client’s sensitivity to losses and the consistency of their financial decision-making processes. This capability, according to the creators of the application, enables advisers to more successfully measure a client’s “true” level of risk tolerance, helping advisers craft more suitable portfolios and facilitate lower levels of client anxiety and stress. Advisers looking to do a deeper dive into the decision-making characteristics of their clients might want to check out TrueProfile.

Another technology, Totem Risk, seeks to address the concern that a client’s risk tolerance level may change over time, depending on life circumstances. Their application distinguishes between risk capacity—that is, the amount of risk a client is capable of taking on given their financial situation, and their risk tolerance level. Totem Risk questionnaires generate three scores: (1) a risk capacity score based on the investor’s current life situation; (2) a risk preference score showing the investor’s psychological preference for risk (which may change frequently); and (3) a portfolio risk score showing where the investor’s portfolio is now.

Finally, Whealthcare Planning offers a profiling tool designed to measure a different type of risk—personality traits that make a person vulnerable to poor financial decision-making and/or financial abuse. Someone who suffers from diminished capacity is unlikely to be able to complete a risk tolerance questionnaire with any degree of reliability. In fact, their risk tolerance score is likely to be misleading, transitory, or both, and could suggest recommendations that are highly inappropriate for the client. If you are concerned about a client’s ability to make sound financial decisions, consider using the Whealthcare Risk Profile assessment, or seek advice from a medical professional.

Endnotes

  1. ​See “Prospect Theory: An Analysis of Decision under Risk,” by Daniel Kahneman and Amos Tversky in Econometrica, Vol. 42 No. 2 (March 1979). Available at jstor.org/stable/1914185.

  2. See Paul A. Samuelson’s 1947 book, Foundations of Economic Analysis (Harvard ​University Press).

Did You Know?

As an FPA member, you receive discounts on various products and services to help you run your business, including the following discounts on risk assessment technology:

Tolerisk is a patent-pending, two-dimensional assessment designed to let advisers analyze their client’s willingness to accept risk using a traditional psychometric profile and their ability to take risk, by analyzing their cash-flow chronology.

FPA members receive a 10 percent discount on any Tolerisk subscription service.

TrueProfile’s Risk Essentials product reveals a client’s risk tolerance, loss aversion, and decision consistency as defined by economic science, providing statistical confidence.

FPA members receive special pricing of $79 per month for TrueProfile Risk Essentials during your first year on an annual contract.

Visit Member Discounts to learn more.

Journal staff

Topic
Investment Planning