Most planners have struggled at times to deal with "difficult" clients. Sometimes it's the client who says he's really tolerant of risk and wants 30% returns... until the decline comes. Other times it's the client who refuses to tolerate any risk whatsoever... yet laments the low returns that entails. Accordingly, most planners try to avoid working with clients at the extremes of risk tolerance (or lack thereof). But the truth is, these challenging clients usually do not really have extreme levels of risk (in-)tolerance... instead, the problem is actually with their risk perceptions, and it requires a different solution.

The inspiration for today's blog was a conversation that arose during my presentation "Rethinking Risk Tolerance" when I was speaking yesterday for FPA Los Angeles (based on an issue of The Kitces Report I wrote back in September of 2008). In the presentation, I spend some time exploring the difference between a client's risk tolerance attitudes - the willingness to accept an uncertain and possibly unfavorable outcome in pursuit of a better result - and the client's risk perceptions - how risky they perceive their own investment or other behaviors to be.

This distinction between risk attitude and risk perception is crucial, because what I find in conversation with planners is that most of the things we attribute to our clients' risk tolerance attitudes are actually problems of perception instead. Risk attitude is a psychological trait - our ingrained willingness to seek risky trade-offs, and although it varies by person, it's actually remarkably stable throughout our lifetimes. Risk perception, on the other hand, fluctuates continuously as we constantly re-evaluate the risk of what we're doing and try to decide if it's consistent with our comfort level.

Perhaps a non-investment example will help. You're driving down the highway. The speed limit is 65mph, but you're driving at 72mph. Which means either by deliberate or subconscious choice, you've decided that you're willing to risk a modest speeding ticket, in exchange for getting to your destination a little faster. You've made a behavior decision about the risk-return trade-off, based on your risk attitude. Now, let's assume that as you're driving down the road, you actually drive by a police speed trap. Relieved, you see that the officer is not pursuing you. Nonetheless, the driver reaction is virtually always the same - we start driving a little slower for a while. Reminded of the fact that speed traps really are nearby and there could be another one soon, we perceive the risk of getting caught as elevated, and modify our behavior accordingly. It's still true that the driver is willing to go 72mph in a 65mph zone in exchange for a low risk of getting caught; what's change is not the driver's attitude about risk, but his perception that the risk of getting caught might be a lot higher than he first realized.

So now let's translate this to the investment world. Each of our clients have a certain risk attitude - a willingness to pursue a favorable investment outcome, with the uncertainty and risk that a less favorable result could occur instead. And in point of fact, recent research by Michael Roszkowski and Geoff Davey has shown that our risk tolerance is actually rather stable throughout good and bad markets; once again, whatever willingness we have to make trade-offs when we're born is the trade-off we tend to be comfortable with for life. On the other hand, our perceptions of risk are not so stable. When everything is going great - the highway is clear, and the markets are going up and up - we just don't perceive much risk of getting caught or something bad happening. The world of behavioral finance has taught us about many of the mental shortcuts we take that lead us to often faulty conclusions, from our overconfidence in our (investment selection) abilities to our strong bias to extrapolate the recent past into the indefinite future (recent bull markets mean stocks are growing to the sky; a bear market means everything is heading to $0).

Accordingly, when there's a bull market, and we become increasingly confident that it means stocks are going to generate tremendous wealth, we dial up on stocks, because we don't perceive them as being risky! Our mental shortcuts for evaluating their risk tells us that they're going up, the trend will probably continue, that we're brilliant at selecting winners, etc., etc. Conversely, when the market does turn, we go through a tremendous re-adjustment in our perceptions of risk. And because we have loss aversion tendencies - we experience more negative feelings at losses than we do positive feelings about comparable gains - we tend to adjust our perceptions of risk very quickly in the face of losses. But it still remains true that our willingness to take a certain risk in pursuit of better results hasn't really changed; what's moving - all over the place - is our own perception of how risky our (investment) behaviors are in the first place. We buy lots of stocks in bull markets not because we want to take more risk, but because we don't perceive them to be risky! And we want to sell the stocks in a bear market because we suddenly (over-)estimate them to be far more risky than we originally thought, and decide that the risk trade-off isn't worthwhile after all. Our brains perceive the investment to be riskier than what the kind of trade-off we are willing to tolerate, so we want to sell.

What does all of this mean for the financial planner? It means that when we're struggling with clients who want to keep making portfolio changes in volatile markets, the reason is not that their risk tolerance is fluctuating wildly; it's that they are making rapid changes to their perception of risk, and (mis-)judging their portfolio to be too risky, then not very risky, then too risky, then not very risky.

In turn, this means that the primary role for financial planners is truly about managing perceptions of markets and risk; in essence, to manage expectations so that clients properly understand how risky their portfolio actually is, and don't over- or under-estimate it. In addition, it also means that those really "difficult to manage" clients are not actually the very risk-inclined ones, nor the risk-averse; it's the clients who are most volatile in their risk perceptions, going from one extreme to another and believing that they need to make investment changes at each step along the way.

So what do you think? Is this consistent with your experience with clients - that it's actually their risk perceptions that fluctuate wildly, and that must be constantly managed in turn? Are the clients most difficult for you to handle the ones who have the most variation in their perceptions of market risk over time?

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  • Mike McDaniel

    Most advisors do not have an objective, unemotional, quantitative way to 1.) Extract/pinpoint their client’s risk tolerance 2.) Express in dollar terms what the downside/upside potential is for said client portfolio.

    It is my view (12+ years as a risk manager) that when client’s believe I know and can match their risk tolerance with the risk (downside and upside) in their portfolio they will stay the course. Since I started showing clients how I match their individual risk tolerance with the right amount of market risk I no longer have clients making emotional (irrational) decisions.

    Regarding expectations: how can an advisor express the risk to clients if they don’t know it themselves? Again, if an advisor doesn’t know the downside and upside risk to a client’s portfolio how can they possibly set expectations?

    Every client portfolio I manage is in Riskalyze and I know how much risk is in their portfolio. I can set and manage expectations (including using various stress tests) before the inevitable crash (stock, bonds, commodity, real estate, etc) and insure against clients getting irrational as risk perceptions change. That is how I add value.

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Michael E. Kitces

I write about financial planning strategies and practice management ideas, and have created several businesses to help people implement them.

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