Regulators around the world require financial advisors to assess their clients’ risk tolerance to determine if an investment is suitable for them before recommending it. For the obvious reason that taking more risk than one can tolerate will potentially lead to untenable losses. And even if the investment bounces back, an investor who loses more money than he/she can tolerate in the near term may sell in a panic at the market bottom, and miss out on that subsequent recovery.
Yet the reality is that many investors end up owning portfolios that are inconsistent with their risk tolerance, and it’s only in bear markets that they seem to “realize” the problem (which unfortunately leads to problem-selling). Which raises the question: why is it that investors don’t mind owning mis-aligned and overly risky portfolios until the moment of market decline?
The key is to recognize that investors do not always properly perceive the risks of their own investments. And it’s not until the investor’s perceived risk exceeds his/her risk tolerance that there’s a compulsion to make a (potentially ill-timed) investment change.
Yet the fact that investors may dissociate their perceptions of risk from the portfolio’s actual risk also means there’s a danger than the investor will misperceive the portfolio risk and want to sell (or buy more) even if the portfolio is appropriately aligned to his/her risk tolerance. In other words, it’s not enough to just ensure that the investors have portfolios consistent with their risk tolerance (and risk capacity); it’s also necessary to determine whether they’re properly perceiving the amount of risk they’re taking.
And as any experienced advisor has likely noticed, not all investors are equally good at understanding and properly perceiving the risks they’re taking. Some are quite good at perceiving risk and maintaining their composure through market ups and downs. But others have poor “risk composure”, and are highly prone to misperceiving risks (and thus tend to make frequently-ill-timed portfolio changes!).
Which means in the end, it’s necessary to not only assess a client’s risk tolerance, but also to determine their risk composure. Unfortunately, at this point no tools exist to measure risk composure – beyond recognizing that clients whose risk perceptions vary wildly over time will likely experience challenges staying the course in the future. But perhaps it’s time to broaden our understanding – and assessment – of risk composure, as in the end it’s the investor’s ability to maintain their composure that really determines whether they are able to effectively stay the course!