Managing Risk Tolerance

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ManagingRisk Tolerance

• Geoff DaveyCo-Founder FinaMetrica Pty Limited

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Managing Risk Tolerance

• Assess your clients financial risk tolerance.
• Apply that assessment when formulating advice.
• Obtain your clients properly informed commitment.

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Whatisrisktolerance?
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Risk Tolerance
Comfort Zone
RiskSeeking
RiskAvoiding
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• Risk ToleranceHow much risk I choose to take.(a
  psychological construct)
• Risk CapacityHow much risk I can afford to
  take.(a financial construct)

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The Meaning of Risk Profile

• An assessment of an individuals risk tolerance.
• or
• An assessment of the risk(/return) in an
  investment strategy (thought to meet the clients
  needs.)

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Psychological Trait

• A relatively enduring way one individual differs
  from another.

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Financial Risk Tolerance

• The extent to which an individual would normally
  choose to risk experiencing a less favourable
  outcome in the pursuit of a more favourable
  outcome.
• ISO Personal Financial Planning Standards

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Whats yourrisk tolerance?
Uh?
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Test Development
Pool of Questions
Sample Questionnaire

• Useability Trials
• Understand?
• Answer?

Norming Trials

• Statistical Analysis
• Validity?
• Reliability?
• Accuracy?

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Insights from Psychology and Psychometrics on
Measuring Risk ToleranceJournal of Financial
Planning, April 2005
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Industry-Standard Questionnaires

• Too many bad questions.
• Too few good questions.

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Reliability

• Test Score True Score Error
• Reliability (r) Correlation between Test Score
  and True Score
• Error (SEm) StdDev x ?(1-r)
• Reliability (r) f(no of questions2)

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Risk Tolerance Characteristics

• 4 types physical, ethical, social and financial
• Normally distributed
• No sub-factors
• Males gt females by 1 sd
• Negative correlation with age, marital status and
  dependants
• Positive correlation with income, assets and
  education
• Advisers gt clients by 1 sd
• Clients estimates correlate .68
• Advisers estimates correlate .38

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Adviser Anomalies

• Different advisers have different interpretations
  of same statement.
• Gender stereo-typing
• Males ? Females ?
• Client self-estimates more accurate than adviser
  self-estimates and adviser client-estimates.
• Advisers use flawed heuristics.

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Standard Methods
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Risk Tolerance / Risk Aversion Linkage

• 162 respondents who had 6 - 24 months earlier
  completed a FinaMetrica risk tolerance test.
• Invited to play online lottery choice games with
  hypothetical and real (20,000) payoffs.
• Risk tolerance score was a strong predictor of
  risk aversion behaviour in the lottery.

Robert Faff, Daniel Mulino and Daniel Chai,
Monash UniversityThe Journal of Financial
Research Vol. XXXI, No. 1 Pages 123 Spring
2008
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Managing Risk Tolerance

• Assess your clients financial risk tolerance.
• Apply that assessment when formulating advice.
• Obtain your clients properly informed commitment.

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Gap AnalysisThe gap between

• risk required (the risk inherent in the return
  required to achieve goals)
• risk capacity (the maximum affordable risk)
• risk tolerance (the preferred risk/return
  trade-off)

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Gap Analysis

• Bill and Suzie need an aggressive portfolio (90
  growth) to achieve their goals, but
• Bills risk tolerance indicates he would normally
  choose a conservative portfolio (40 growth) and
  Suzies suggests a balanced portfolio (60
  growth).

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Linking Spreadsheet
Risk Tolerance
Risk Required
Methodology for comparing portfolio risk to
risk tolerance
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Expressing Scores as Growth Assets
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Comfort/Discomfort Zones
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Resolving the Gap

• Take more risk, and/or
• Lower goals and/or
• Invest more

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The Planning Process

• Assess risk tolerance.
• Determine risk (return) required.
• Gap analysis and resolution.
• Explain risk.
• Obtain properly informed commitment.

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Explaining Risk
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Monthly Volatility(How often does it rain?)
Cash 5Fixed Interest 25 US Stocks 50Intl
Stocks 20
1972 - 2008
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Falls Analysis(How heavy and for how long?)
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Top Ten FallsBig Wets
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Properly Informed Commitment
Clients better understand and are more
committed to your advice because

• risk tolerance was properly assessed,
• gaps were identified meaningfully,
• trade-off decisions were made knowingly, and
• the risks were explained in a manner that the
  client could understand.

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www.riskprofiling.com free 30-day trial
geoff.davey_at_finametrica.com