What Drives Risk Tolerance
August 4, 2015
by Daniel Solin
Pros And Cons Of Tail Risk Funds
Editor’s note: This article is part of a series ValueWalk is doing on tail risk hedge funds. The series is based on over a month of research and discussions with over a dozen experts in the field. All the content will be first available to our premium subscribers and some will be released at a Read More
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Few issues are more important to investors than risk. A primal fear among investors is that they will run out of money in retirement and be forced to compromise their quality of life or even become homeless. One study found that nearly half of women in the United States who make more than $30,000 a year are afraid they will end up on the streets. Even more surprising, 27% of women with salaries of more than $200,000 expressed the same fear.
Fear of being homeless is so common it even has a name. It’s called peniaphobia.
To be a successful advisor, you need to understand how risk affects the decisions investors make and what you can do to make those decisions more objective and responsible. Demonstrating value at a time when investments are becoming more of a commodity is a popular topic in advisor-industry circles.
I can think of no greater value you can provide than bringing objectivity to this very emotional issue.
First, you need to understand what really drives risk tolerance decisions.
Loss aversion and risk tolerance
Studies have shown that the fear of losing money is the primary factor for how much risk an investor will tolerate.
This is an important finding for advisors. Previously, it was thought that changes in spending habits and consumer sentiment most impacted investor decisions about risk tolerance. However, if you accept the conclusion that loss aversion is the primary driver of risk tolerance, then you are confronted with a common dilemma. You understand more exposure to stocks will generate a higher expected return over the long term, but how do you deal with a prospect who tells you she cannot tolerate a meaningful drop in the value of her portfolio, even if it’s temporary?
The author of one such study, Michael Guillemette, an assistant professor at the University of Missouri’s College of Human Environmental Sciences and a certified financial planner, counsels advisors to reduce loss aversion anxiety by telling prospects and clients to view their returns less frequently (for example, annually instead of monthly).
Many advisors begin client meetings by reviewing portfolio performance. In bull markets, it’s tempting to do so because it’s easy to convey good news. However, this protocol may be counterproductive in bear markets. Guillemette believes the client will expect the same emphasis on returns when the portfolio is experiencing losses. Instead, he suggests focusing on “other value-added aspects of financial planning such as estate planning, insurance, taxes and long-term retirement goals.”
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