InvestmentsJul 22 2021

How much risk is your client willing to take? 

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How much risk is your client willing to take? 
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Risk is in attendance at every decision we make, yet questions like ‘how much risk are you willing to take?’ prove very difficult for most people to answer.

At the very extremes of risk taking and risk aversion this distinction may be a bit clearer – but then, few people fall at the extremes of a distribution.

Nevertheless, this is the kind of question that financial advisers need answers to. Regulators around the world require that a client’s risk appetite should be taken into consideration when recommending products that they deem appropriate.

Personality psychology highlights extreme variation in people’s propensity for risk taking, although self-awareness tends to minimise these differences.

If we are unable to characterise our own risk disposition with any confidence, the challenge faced by advisers in meeting this regulatory requirement is all the more problematic. 

Looking at risk taking from a different perspective, Covid-19 has illustrated the very wide range of reactions to risk and uncertainty across the population. It has been suggested that the more risk averse will still be wearing masks even when the mandate for doing so is long past, whereas others will have viewed masks as an intolerable violation of personal freedom from the outset.

The wider perspective on risk taking includes ‘bring it on’ people prepared to put their life on the line, whether in sport, gambling, or business adventures. At the other extreme are clients in fortress-grade, burglar-alarmed homes, others for whom supermarket ‘display until’ dates trigger binning, or some whose obsessionally detailed holiday planning destroys all possibility of relaxation. People are just that different – the colourful pageant that is humanity.

Risk: emotion and cognition

At their root, risk dispositions are hard-wired. Neuroscience identifies two systems in the brain that contribute to decision making: one concerned with emotion, the other with cognition, and decision making always involves risk.

Findings from personality science support this analysis. The levels of risk that we are willing to accept in our occupations provide a very strong endorsement of this view. 

You will not find many risk-averse people working at the drill head on a North Sea oil rig, nor will you find excitable risk-takers working in accounts.

Risk disposition, however, is not always a criterion for job selection, and there are certainly roles in which personality would make little difference, or in which many different risk types would actually be a benefit. The role of air traffic controller is certainly not one of them.

In a series of replicated studies, air traffic controllers, as a profession, have been shown to be very similar in their risk-taking propensities.

They are likely to be meticulous in terms of processes and procedures and very compliant and attentive to detail. That is the cognitive side of their nature that is evidently risk averse; they like to work within a framework with very clear boundaries, and need to know exactly what to do in every conceivable circumstance. Of course, their training encourages this outlook, but the fact is that nearly everyone attracted to the job brings similar risk dispositions with them.

There is another side to their nature however, the emotional side, which, paradoxically, is at the high extreme of risk tolerance. This is what ensures that, whatever the circumstances, they will stay calm and unruffled. Air traffic controllers are wired not to panic when things go wrong. 

Like air traffic controllers, we all have a cognitive and an emotional side to our risk dispositions representing two distinct and separate brain systems.

These interact to create the considerable variety in individual approaches to decision making. Combining these foundational measures of cognition and emotion orthogonally creates a complete 360 degree spectrum of risk dispositions.

For purposes of interpretation and communication, this can be segmented into eight distinctive risk types. Everybody sits somewhere in that matrix. 

Providing a framework

Psychometric questionnaires can deliver reliable and objective measures. Interpretation is based on extensive data and research findings, providing a framework and a vocabulary that structures purposeful discussions rather than relying on the variable and conflicting insights of different individuals.

In many ways, it is easier to objectify the risk dispositions of clients than it is to objectify the risk associated with financial products.

People are more consistent than markets. Advisers cannot be expected to add personality psychology to their skill sets. But, familiarisation with a well-defined framework of risk appetites and developing an understanding that can be shared with clients is readily attainable.

It makes an effective contribution in terms of communication and discussion. ‘How much risk are you willing to take?’ becomes an eminently answerable question. 

The emphasis in probabilistic reasoning has focused on uncertainty and the risk associated with financial products, rather than on people differences.

Estimates of expected utility recognise that people in different financial circumstances will differ in their perceptions of risk. However, reliance on wealth alone as a differentiating factor grossly oversimplifies the reality of the variability of client risk dispositions.

Differences in circumstances are important of course, but risk type is likely to be as variable among the wealthy as it is among the more hard pressed. Human nature trumps circumstances when it comes to decision making.

If we are advising mask-wearing clients to invest in bitcoin, we are probably getting something wrong.

Geoff Trickey is chief executive of Psychological Consultancy and founder of the Risk Type Compass