Chasing past performance represents the sacrifice of future performance in exchange for current comfort. The reason investors make decisions that harm their long-term investment returns is rarely a lack of knowledge.While investors are wired the same way worldwide, subtle cultural nuances can mean what works in one place doesn’t work in another. It’s not always obvious where the cultural fault lines lie.Innovative advances in technology, data analytics, and behavioural design can allow advisers and institutions to provide better behavioural prescriptions for everyone, both at the start of an investment journey, and along its course.
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.
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.
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.