What Is the Misunderstanding of an Investor's Risk Profile?

In my journey as a wealth mentor over the last 20 years, and developing a rigorous scientifically based behavioral finance approach for the last 15, I have watched the risk profiling discussion seriously evolve from denigration to one that is being more intelligently embraced and applied. From advisors, clients, compliance departments, and regulators: what is the misunderstanding of an investor’s risk profile?The problem is a combination of factors:

Lack of clarity in the terminology as to what defines risk profile. For instance, interchanging risk tolerance, risk perception, and risk capacity although all have different meanings.

Regulators worldwide have created principles based laws around risk profiling. But the legislative vagueness leaves too much open for interpretation leaving many firms doing virtually nothing.

Compliance departments allowing “tick-the-box” methods of risk profiling along a broad array of approaches from doing nothing, to guessing, observing, or 3-to-5 hacked together questions.

Applying the risk profile in a linear way based on a single measurement.

Lack of understanding risk profiling at a deeper level because many of the instruments and processes are slapdash and poorly constructed. Even the better tools are one dimensional but are used to measure all aspects of risk, which is wrong and misleading.

The Inability of advisors/consultants to integrate risk profiling and behavioral discovery into the client onboarding process.

An unwillingness to have the client invest time in additional questionnaires viewed as distracting from getting on-boarded.

The plethora of online investing platforms leveraging a quick & dirty approach to “knowing the investor” without any real insights.

The positive development now is that there is a heightened awareness of the need to adopt a more formalized behavioral discovery process, recognizing that risk taking, tolerance, and loss aversion are separate and measurable personality traits. And it’s a combination of all the risk factors, along with many cognitive biases, that interplay in how decisions are made.Further, the compliance environment is requiring a strengthening in processes because the #1 issue on the agenda of regulators is dealing with the increase in investor complaints from a lack of suitability. Suitable solutions will never be able to be satisfactorily offered with demonstrated client buy-in unless EACH of the multi-dimensional elements that make up the risk profile is understood by both the advisor and the client.For the last 15 years in my role as a wealth mentor, I have been guiding advisors and clients to understand the multi-dimensional nature of their risk profile as highlighted in the table below.A risk profile is not a single number determined in a vacuum. In fact, it is a quantifiable number made up of many measurable financial and personality based elements. Whether you use the Financial DNA Discovery Process or other platform, I suggest you follow these key steps to identify and apply risk profiling: 1. Use the client’s long-term risk profile for building a long-term portfolioand predicting how they will intrinsically make decisions over the long term (this is what Daniel Kahneman refers to as the Level 1 behavior). The correct questionnaire structure is absolutely critical to getting this result. In my terms, this is the hard-wired natural DNA Behavior. The questionnaire should be designed and independently validated based on sound psychometric principles. 2. Understand the short-term risk profile based on current situational attitudesand how the client manages themselves ( Kahneman’s Level 2 behavior). This is what many risk tolerance questionnaires seek to measure with varying degrees of quality and accuracy. 3. Separate the various calculations of the Risk Need to achieve the client’s goalsand Risk Capacity being their financial ability to sustain losses from the various personality traits associated with risk, risk propensity (desire to take risks), risk tolerance (emotional ability to live with losses), loss aversion (emotional reaction to markets), risk and product perception (reaction to situations and products ), and risk preferences (personal evaluation of preparedness to take risk in a given situation or with a product). 4. Know each client’s Risk Composure– how they are feeling during up and down market movements. Some will embrace down markets and others will fear them. Of course, added to this is knowing how to communicate with clients during these different times. 5. When wealth mentoring the client, help them set purpose based goals that are clearly defined for keeping them focused on what’s important. An IPS can be used as the guide-stick and for getting the client’s emotional buy-in. 6. Finally, as an advisor, know the influence of your own risk profile and behavioral biases.Your mindset can inadvertently play out with the client whereby over time they eat your risk profile.