But it’s important to remember that risk-tolerant investors are not immune to negative reactions. Whether these are emotional reactions, thoughts or actions, we should avoid holding such high expectations of how risk-tolerant investors will fare when faced with financial adversity.
Second, when faced with real-life challenges, an individual may realise they don’t have the resilience to overcome such obstacles in the way they initially thought, causing them to act in a detrimental manner. Financial planners must observe the inconsistencies between the client’s attitude to risk and their behaviour when real-life uncertainties arise to help the client develop financial resilience.
Measuring risk attitudes holistically through a robust and standardised process allows a financial planner to be well informed not only about the client’s levels of risk tolerance, but also emotional resilience, capability and confidence in managing their finances.
When used as part of a wider discussion about risk, a reliable risk-tolerance test can not only be an essential investment planning tool, but can provide the adviser with a deeper understanding of the values and beliefs that lie behind a client’s apparent overconfidence.
By incorporating emotion-based statements within an attitude to risk questionnaire, an adviser will be armed with information on how their client is likely to respond in different situations. This holistic understanding of the client’s unique situation means the adviser can tailor both the conversations they have and the support they provide
At the same time, the client is brought more closely into the financial planning and advice process, deepening the relationship with the adviser and helping to turn an overconfident investor into a confident and competent one.
2. Explaining psychological biases that investors should avoid
There are a number of different personality traits that can influence our susceptibility to behavioural biases, according to academic research. So, a key role of the adviser is to educate clients around these biases and their potential to influence risk tolerance and expectations during the investment journey.
Overconfident investors can benefit from understanding the perils of behavioural biases such as anchoring and herding, so that they are able to identify and avoid these traits in themselves.
Investors vulnerable to anchoring must be encouraged to make research-based decisions and reject the use of historical values and other irrelevant information.
For those susceptible to engaging in herding behaviour, it’s crucial they avoid attempting to time the market and instead remain invested and follow their long-term plan.
Understanding how these behavioural biases impact investment decisions—and taking measures to counteract them—can reduce the likelihood of investors making poor investment choices, while also contributing to more robust markets on a wider scale.
3. Creating a diversified portfolio