While we often focus on “risk tolerance,” when the markets head up or down precipitously, managing your clients’ risk perception is actually the key.
Of course, to do so, we must first understand the difference between risk tolerance and risk perception. In a nutshell, the reason why people’s risk tolerance can change drastically during times of market volatility has to do with this notion called risk perception.
Research shows that risk tolerance is a fairly stable “personality trait”—which stays the same unless someone has a life-changing experience. Risk perception, on the other hand, is an emotional, temporary judgment of the severity of a risk during a certain time frame.
A heightened perception of risk can come and go fairly quickly. But when it’s in play, your clients’ short-term decision-making—how well they maintain an even keel during market swings—is what matters. So, in addition to considering your clients’ fundamental risk capacity and tolerance, coach them on how to keep their composure when the markets are doing particularly well or poorly. These techniques will allow you to keep more focus on financial planning, and less on managing tricky client behaviour.
Risk Tolerance Vs. Risk Perception
To illustrate the difference between risk tolerance and risk perception, let’s consider a driving analogy.
Imagine you’re driving down a winding road you know fairly well. You’d like to listen to music you recently downloaded, so you look down to grab your phone from the console. By the time you look up, you realize the road has curved left, and you’re about to run right off it!
Fortunately, you react in time and swerve back into your lane. For the next 10 minutes, regardless of whether you’re typically a careful or aggressive driver, you drive as carefully as possible because your mind is very conscious of (if not overestimating) the risk. Of course, you’re the same person you were 10 minutes ago (and have the same risk tolerance). But due to almost running off the road, your awareness of danger (your risk perception) has skyrocketed.
Your typical driving style is guided by your automotive risk tolerance, while your risk perception is guided by this potentially deadly near miss. So, while interrelated, risk tolerance and risk perception are fundamentally different things. Of course, one’s objectives and tolerance for risk should drive one’s investment strategy. But risk perception is the element that can cause clients to push for a more aggressive portfolio when the market is at a high point, and for moving to cash when the market is moving down.
Talking to Clients About Risk Perception
Use a relatable analogy. Given current worries about the economy and markets, now is a good time to introduce or reinforce the notion of risk perception. Share the driving analogy with your clients. It’s an effective way to let them know that although risk perception is emotionally real, it causes us to downplay or inflate the dangers we face. By educating clients about risk perception, we can help them avoid poor decision-making and self-destructive financial behavior.
Ask clients if they’ve experienced swings in their perception about the risks of investments and, if so, what action they took. If clients express any regrets, ask what they would like to do in the future and how they’d like you to help them stick to that choice. For some clients, a talk like this is enough to manage their perceptions and encourage greater risk composure going forward.
Share distraction strategies. You can also ask clients what strategies they have used to help them get through moments of panic in the past. You could suggest something like:
Go on a news diet by tuning out the websites, TV channels, and radio stations that induce panic.
Dive into a hobby (especially one that gets them moving physically, into nature, giving back, or into a social setting, as these hobbies are highly correlated with causing sustainable positive emotions).
Have clients ask you to rerun projections for their financial plan based on market actions to pressure test the drops.
These strategies apply to good times as well as bad. It’s important to keep in mind that when the market is too good for too long, risk perception can decrease to an unrealistic level (just as we can get too relaxed when driving on a long stretch of empty highway). During strong markets, clients might want to move into a more aggressive investment allocation than their risk profile warrants. So, remember to encourage clients to maintain their composure in good times as well as bad.
When dealing with emotional situations, it’s easy to let ourselves be overcome by “compassion fatigue.” This condition can occur when we spend so much time and energy empathizing with others that we ourselves feel overwhelmed. Compassion fatigue is well-known in medical and therapy professions, but it’s also common in the advisory field.
So, make sure you have a plan to nourish yourself, perhaps by turning to your favorite activities for self-care just as you suggest that clients do in times of stress. By preparing your clients—and yourself—for market ups and downs, you’ll be well equipped to manage clients the next time their risk perception skyrockets, whatever their risk tolerance.
Kol Birke, CFP®, is managing principal, corporate strategy and financial behavior specialist, at Commonwealth Financial Network.