The third is “risk tolerance.” Professor Kariv’s research suggests that a person’s risk tolerance actually has multiple components. They include “risk aversion,” “loss aversion” and “ambiguity aversion.” Let’s look at each one separately.
Alex Honnold ascended the 3,000-foot granite wall known as El Capitan in just under four hours without ropes or safety equipment. For someone else, a brisk one-hour bicycle ride on a paved path is pushing the limits. Honnold is less risk averse than our bicycle-riding friend.
Loss aversion is a separate and distinct component of risk tolerance. People vary in how they weigh the potential for gains and losses and in the way they react to losses once they occur. Even a bold adventurer like Honnold could be quite loss averse when it comes to investing and our bicycle-riding friend could surprise us by taking extreme market volatility in stride.
How a person deals with ambiguity is another distinct component of risk tolerance. A person who deals well with known risks may not be as comfortable making decisions in an environment of uncertainty. Honnold studied and trained for years for his El Capitan ascent. He knew precisely the nature and magnitude of the trial he faced. He could calculate his odds of success. But that does not mean that he would be comfortable committing a large portion of his net worth to the vagaries of the market.
To appropriately tailor the advice we give clients, we should understand the multiple components of their risk tolerance. We should understand their willingness to take on risk, their aversion to loss and their aversion to ambiguity. These are all measurable.
The fourth aspect of a client’s risk persona is “risk perception.” This refers to the person’s attitudes about the likelihood of bad events occurring. Optimists see the possibility of bad events occurring as less likely. Pessimists see them as more likely. Knowing where your clients stand can help you better counsel them before and after bad events.
An Opportunity to Stand Apart
Professor Kariv’s research shows that we still have a long way to go in understanding our clients and being able to appropriately advise them given their unique goals, constraints and behavioral characteristics. Yet understanding how your clients make decisions and how they are likely to react in times of stress is crucial to designing plans and portfolios for them.
In response to the need for a better profiling tool, Kariv and his colleagues have developed “TrueProfile,” a program that incorporates the concepts underlying his research. You can learn more about his research at www.TrueProfile.com.
Think of client profiling as a separate part of the client on-boarding process. Develop a strategy, tools and work flows to support that process. Spend the time necessary to understand the needs and characteristics of each client so you can offer the services and support that is most likely to get them to their long-term goals. Your clients will appreciate it because client profiling puts them, rather than their plans or their portfolios, at the center of the process.