Risk is not about the journey; it’s about where you could end up. It is the risk of money not being there when it’s needed, reflecting both the chance and the severity of poor returns.An investor’s risk tolerance is their willingness to accept the chance of bad final outcomes in the hope of good ones. Risk management is therefore investor-specific, because for an outcome to be bad, it needs to be bad for someone.Risk avoidance isn’t risk management, and forgoing the chance of higher returns is often an excessive price to pay for being more comfortable with short-term turbulence.
Investment plans that ignore, or pay only the whisper of lip service, to investor behaviours, are ultimately futile. Ultimately, the true job of a financial adviser is not to give clients a theoretically ‘optimal' solution, but to give them the best solution they could realise in practice.An investor's feelings are part of an investment's total return. In investing - and in financial decision-making generally - the right thing to do for long-term financial wellbeing is invariably an uncomfortable thing to do.A suitable investment portfolio should be judged not only by whether it could ultimately afford the investor the opportunity to do what they wanted to do when they put the plan in place but also by how the investor felt during the journey, and the costs of all those emotional deviations from the plan along the way.
Classical finance asks us to believe the investment journey does not matter. That is a mistake. Ignoring strong intuitions of the investors who have to endure the journey is always a mistake.When we lack comfort with our portfolio, we will act in costly ways to acquire it. And not all of those ways are created equal.Behavioural profiling allows us to predict in which ways we’re likely to make poor decisions, and helps us to avoid them. It helps us to acquire the emotional comfort we need in a cheap, planned, and efficient way.
Financial returns aren’t the only thing investors value.Financial returns aren’t just a means, they can be an end.Investors need to feel comfortable with their portfolio if they are to succeed.
By conflating risk tolerance with behavioural risk attitudes, advisers will potentially replicate (or optimise for) all the silly things investors do already, rather than helping to mitigate and control investors’ more-destructive tendencies.A common failure of risk profilers is to try to elicit separate measures of tolerance for different subcomponents of a client’s overall wealth.If we genuinely want to determine the right amount of risk, it is not sufficient just to measure risk tolerance. It is also not sufficient to supplement this with a narrow model of risk capacity. We also need to help people understand, articulate and dynamically adapt their future goals, plans and aspirations over their journey.