Your Clients Are Clueless About Their Risk Tolerance

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Determining your client’s risk tolerance is a critical first step in constructing a tailored investment portfolio.

Misjudging a client’s risk tolerance can lead to a host of problems. If clients take on too much risk, they are more likely to panic during market downturns. If they are too conservative, they may miss out on growth opportunities, limiting their ability to meet long-term financial goals.

The typical approach

Many financial advisors use standardized questionnaires to assess a client’s risk tolerance. These questionnaires ask clients about their:Investment goals: What do they hope to achieve?

Time horizon: When do they need the money?

Financial situation: What is their income, savings, and asset level?

Risk appetite: How would they react to potential losses?

The idea behind these questions is to categorize clients into broad risk profiles: conservative, balanced, or aggressive. Based on this categorization, you recommend portfolios that align with the client’s stated tolerance for risk.

Here's the problem: A risk tolerance questionnaire may capture a client’s articulated views on risk tolerance, but (as many advisors can attest) it misses factors that may determine how they react in real-world situations.

Stated versus actual risk tolerance

Studies demonstrate a gap between the stated and actual risk tolerance of investors.

In one of them, researchers asked 2,226 people questions to understand how they perceive risk when investing. The goal was to understand which types of risk they focus on without realizing it. The researchers found investors often say one thing about their view of risk but behave differently when making actual decisions.

Although they state that their primary concern is preserving their initial investment or comparing returns to a risk-free rate, their behavior reveals they are more focused on outperforming the broader market. Investors with this mindset may be more competitive and market-focused than they admit, which could lead them to take on more risk than intended to achieve market gains.

Most investors use more than one factor to assess risk, even if they’re unaware of it. Generally, it’s a combination of factors, including past experiences, investment goals, and psychological biases.

Financial sophistication

The financial sophistication of your client is an important factor in their actual risk tolerance.

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One study found that investors with higher levels of financial literacy tend to perceive lower levels of risk, which suggests that the more knowledgeable an investor is about financial products, the less intimidating those products may seem.

While investors may express certain risk tolerance levels, their perceived risk of specific investments is shaped more by their understanding (or lack thereof) of those investments.

An investor may state they are comfortable with taking risk, but when presented with a complex product they don’t fully understand, they may perceive that product as riskier than it objectively is. Or an investor might claim to be open to higher risk but choose more conservative options due to uncertainty or confusion about specific investments.

Psychological factors

A study entitled "Measuring Perceived Risk Based on Investor Psychology" by Zhang Xu found that investors often exhibit overconfidence and biased self-attribution, which leads to a mismatch between their stated and actual risk tolerance.

“Biased self-attribution” refers to investors' tendency to attribute their successes to their abilities or efforts while attributing failures to external factors or circumstances beyond their control.

This psychological bias can distort investors' perception of their decision-making and performance, leading to overconfidence in their abilities and inaccurate assessments of risks and outcomes.

A new approach

To better align with your client's actual risk tolerance, consider a new approach:

Ask follow-up questions: Standard questionnaires should be just a starting point. Ask follow-up questions about how clients felt during previous market events and what financial losses they find unacceptable.

Incorporate behavioral finance: Incorporating behavioral finance into risk tolerance assessments helps account for the psychological aspects of investing, like emotional responses and cognitive biases.

Traditional risk questionnaires often miss underlying factors like overconfidence, loss aversion, or recency bias, which can significantly influence a client’s behavior in volatile markets. By understanding these biases and how they shape decision-making, you can offer more personalized guidance that aligns with a client’s financial goals and emotional comfort with risk.

For example, a client may initially claim to have high-risk tolerance but reveal discomfort with potential losses during hypothetical scenarios. By uncovering behavioral biases, you can recommend a portfolio that better suits the client’s true risk tolerance, balancing growth opportunities with emotional security.

This approach results in more tailored investment strategies and helps clients stick to long-term financial plans without succumbing to emotionally driven decisions during market fluctuations.

Use scenario analysis and stress testing: Walk clients through hypothetical scenarios and stress-test portfolios to show how they might perform under various conditions. This exercise helps clients gain a more realistic view of their risk tolerance.

Educate: Clients overestimate or underestimate risk because they don’t fully understand how different financial products work. Spend time educating clients about the risks and rewards of different asset classes, helping them make more informed decisions.

Final thoughts

These studies show that investor behavior is complex and often contradicts stated beliefs, making it crucial to consider both psychological factors and actual behavior when assessing risk tolerance.

By taking a more holistic approach that includes in-depth conversations, behavioral finance insights, and scenario analysis, you can better understand your client’s true risk tolerance, helping them make more informed and confident investment decisions. Dan coaches evidence-based financial advisors on how to convert more prospects into clients. His digital marketing firm is a leading provider of SEO, website design, branding, content marketing, and video production services to financial advisors worldwide.

Dan coaches evidence-based financial advisors on how to convert more prospects into clients. His digital marketing firm is a leading provider of SEO, website design, branding, content marketing, and video production services to financial advisors worldwide.

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