New Behavioral Finance Study Shows That Current Questionnaires Do Not Serve Investors Well

Friday, August 17, 2012 07:09
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New Behavioral Finance Study Shows That Current Questionnaires Do Not Serve Investors Well

Tags: behavioral finance | client education | risk

Behavioral finance is injecting itself into the questionnaires you typically use with your clients. It’s finding that those questionnaires often come up short—especially in the area of risk tolerance. Most questionnaires confuse risk tolerance with perception of risk. This means there are critical aspects of how clients view risk of which advisors should become aware.

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A new study by Carrie Pan and Meir Statman recently published their findings on the shortcomings of risk questionnaires in the Journal of Investment Consulting. The put their findings straight on the line, saying that many investors were wrongly assessed as risk tolerant in 2007 and promptly dumped their equity holdings in 2008 and 2009, often along with their advisors.
 
Behavioral finance teaches us that the concept of risk in a client’s eyes is often influenced by that client’s current circumstances. So much so that, after a period of high returns, investors’ appetites for risk are even greater, just at the time when the markets are likely to pull back.
 
The behavioral bias of hindsight also comes into play with investors thinking that advisors should have been able to see that a particular investment was a mistake and allowed them to make the investment anyway. The phrase—you should have seen this coming—comes to mind.
 
High risk tolerance is also associated with the bias of overconfidence, making both advisors and investors think they are quite talented at selecting winning investments when they simply were benefiting from a nice market move.
 
Pan and Statman took examples from various firms’ questionnaires to illustrate how the questions on them tend to confuse correlated behavioral biases like confidence with tolerance. Advisors who are aware of these distinctions may be able to tone down investor overconfidence, for instance.
 
The two researchers are calling for new questionnaires that go beyond assessment of risk tolerance. These questionnaires would venture into behavioral biases like propensities for maximization, regret, attributing success to their own abilities, and assessing trust and life satisfaction.

 

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