Where’s the risk? For $100

Andrew Guy
Compliance and Risk
February 19, 2021


Hi 👋 I’m Andrew Guy, and I'm the Compliance and Risk Guy (no pun intended) at Purpose Advisor Solutions. I’m passionate about behavioural finance (as you’re about to find out), and I’ve spent many years learning to apply these concepts to improve clients' investment outcomes. And I’ve concluded that the first step is to address the negative side: risk.

What percentage of your clients are familiar with modern portfolio theory? What about the efficient market theorem? Do you have clients coming into your office letting you know that they require a 7-9% annual return over the next 15 years in order to achieve their goals but that their portfolio volatility must be less than 15%? No, of course not. But the basic know-your-client questions assume that clients understand these theories and can rationally provide this information.

The average client will tell you that they need your help in achieving their investment goals, and that they don’t want to lose any money. They may tell you that they don’t want to lose any sleep as a result of worrying about their portfolios. And that they are going to rely on you to protect them from their tendency to buy and sell at the wrong time, every time.  

This is because people react in predictable ways to events — and these reactions may lead them to make mistakes when the market is most uncertain. There has been plenty of research, and several Nobel Prizes won, explaining these reactions through the study of cognitive and emotional biases. And the job of a Portfolio Manager is to help keep clients on the right path.

At Purpose Advisor Solutions, we set out to build know-your-client tools and products in a way that captures a picture of the client — while taking into consideration their unique behavioural characteristics. We wanted to help advisors understand how their clients will react emotionally when investing and unpack some of their behavioural tendencies. One key lesson in our research was around how clients feel about their goals vs. their comfort with risk — and that is that they consider them separately. So we broke our discovery process into two: goal discovery and a risk discussion.

We wanted to build a risk tool that would facilitate meaningful discussions between advisors and their clients about investment risks. Through our survey and discussions, advisors can discover in advance how their clients feel about risk. In theory, they should know which clients will have adverse reactions to their investments falling during a global economic crisis.

The reason is that a client’s comfort with risk is much more complicated than can be captured in the simple but common question that is asked, "what is your risk tolerance?". This question frankly doesn’t tell you much. You must dive to a much deeper level to truly understand how your clients feel about investment risk.

To understand an individual’s risk tolerance, we need to consider the research, which shows that people are more willing to take a chance if they are trying to recover a financial loss than if they are presented with an option to win an amount of money. To complicate matters, people overweight current or recent events in their consideration of the future. For example, in the midst of a bull market, people tend to think it will continue indefinitely and will want to own what has been going up. And vice versa, in the midst of a market crash, people commonly think markets will never recover. The Psy-Fi Blog has a great glossary of behavioural biases that look at how psychology and finance are tied together — and these behavioural biases must be addressed when asking clients how they feel about risk. So, the goal of our risk tools — currently our risk survey — is to capture the many nuances of real people and their biases.  

We do this by identifying key themes and grouping them to develop a more complex picture of the client. This results in a risk profile through an analysis along five dimensions:

Risk capacity. The ability of a client to experience losses without dire consequences.
Risk tolerance. The client's emotional comfort with the experience of losses.
Risk perception. The view the client has about the current market situation.
Investment knowledge. The client's experience with investing.
Required return. The connection between the client's goals and market expectations.

Each question in our survey is mapped to at least one of these dimensions — and each question was also carefully considered for why it is there and what we hope to discover by asking it. We also adjust the questions to reflect differences in people; the questions for a 40-year-old millionaire will be different than those of a 72-year-old with limited savings. In the end, we can capture a score for each dimension to develop a solid understanding of the client. We also overweight the capacity and tolerance dimensions as we believe they provide the most information to allow a Portfolio Manager to act in the client’s best interest. And ultimately, we want to provide Portfolio Managers and advisors with the tools needed to help them make their clients' lives better.

We capture the responses in our database so we can then analyze the data and determine which questions are working and which ones aren’t. We have already identified a couple of questions where the typical response does not map with the responses on related questions: they won’t be in the next version. This information will also help us iterate the survey to provide a best-in-class way for Portfolio Managers to assess and discuss risk with their clients.

By integrating the principles of behavioural psychology into our data-driven business model, we will be able to provide advisors with new insights into the way their clients are expected to react to market events. Portfolio Managers can also feel more confident that they have invested their clients’ portfolios in the right balance of risky and safe assets. As the database of responses grows, we may also be able to surface valuable insights about clients that we can provide to advisors to improve their overall business. Picture a scenario where we can tell you which clients are likely to call after markets fall 5%, which you can use to be proactive in calling them first to reassure them. We believe that the value of the risk tool goes well beyond simply satisfying the regulatory requirement to collect the data.