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Managing risk in volatile markets:
Part two: The role of financial personality

For Professional Advisers only

The role of financial and emotional abilities to take risk across client life stages

What makes an investment selection suitable? Advisers and regulators agree that it’s about matching the risk an investor is both willing and able to take with that actually being taken.

An investor’s willingness is best represented by risk tolerance – a long-term, stable, psychological trait that requires a psychometric test to be measured reliably (as opposed to an adviser taking a subjective stab at it).

What about ability? Ability is primarily about financial circumstances. What is it that’s being risked, considering the investor’s overall picture? How reliant is someone on their investments to fund their lifestyle? This calls for a quantified and dynamic measure of ‘risk capacity’ – an investor’s ability to fund future financial commitments from their wealth, and therefore their ability to take risk with this wealth without jeopardising these commitments.

However, ability doesn’t stop there. In addition to this financial ability to take risk, each investor also has an emotional ability to take risk: a behavioural capacity that determines how best to interact with investments to ensure ongoing comfort with the risk being taken.

It doesn’t matter how good a plan is if the person it’s written for doesn’t stick to it, or feels sick doing so. Indeed, the theoretically ‘perfect’ portfolio could be the very spark for some distinctly imperfect behaviours. Emotional ability is not about financial circumstances, but financial personality.

Behavioural capacity

To demonstrate the importance of behavioural capacity, we’ll look at three investors – Kim, Sam, and Andy – each with identical risk tolerances and risk capacities. They differ on three key behavioural traits: composure, confidence, and impulsivity, taken from Oxford Risk’s multi-dimensional assessment of financial personality.

How might their different personalities affect how best to engage them? Meet…

Kim - Nervous, unsure, and quick to act

Defined by the unfortunately common behavioural timebomb of low composure, low confidence, and high impulsivity. The key for Kim is avoiding big mistakes, like cashing out entirely when markets fall and impulse and inexperience suggest that avoiding the markets altogether is the only way back to ‘safety’.

Managing low composure and high impulsivity could include:

  1. Simple pre-set rules: Kim should avoid making important decisions in the moment. Pre-set rules allow actions to be taken in the present, based on decisions made in a calmer, cooler-headed past.
  2. Investment to-do lists: To-do lists assuage the need to take action, especially in times of turmoil. Note: ‘sell everything’ is not on such a list.
  3. Automatic investing: This lessens both the ongoing need to make decisions, and stops Kim focussing on a single investment amount resulting in unhelpful short-term performance checking.

Sam - Calm, confident, and quick to act

Defined by high composure, high confidence, and high impulsivity. The key for Sam is avoiding overconfidence, and staying engaged at the right time.

Managing overconfidence could include:

  1. Product selection: Using some less-liquid products can help put a brake on impulsivity as long as the investor understands what they are investing in and why.
  2. Sticking to pre-set review times: Restricting decision-making to specific times helps with focus and reduces the chances of overconfident snap decisions.
  3. Frequent, high-level communication: Stay in contact regularly, but keep communications brief, bringing up investment details only when necessary for making a decision.

Andy - Unengaged

Defined by medium composure, low confidence, and low impulsivity. The sort of investor whose default is apathy born of lack of both confidence and a sense of urgency. The key for Andy is to make investing feel more relevant, manageable, and urgent – to not sit on the side-lines for long periods.

This could include:

  1. Avoiding day-to-day market news: Daily market news amplifies perceived complexity in an off-putting way, and it’s almost never relevant to an individual investor.
  2. Using shortlists, defaults and deadlines: These avoid actions being continually postponed. The default decision-making process should be a shortlist with a default option that Andy has to sign off on.
  3. Using stories: Stories of particular investments can emphasise more engaging aspects or provide a hook for engaging with unfamiliar ones.

Investor management is often just as, if not more, important than investment management.

The consequences of lessons learned, or mistakes avoided, can compound even more dramatically than financial returns.

Investment-management solutions – baking behaviours into the long-term risk level of a portfolio – are usually an unnecessarily costly way to provide an investor with comfort, relative to investor-management ones of tweaking decision-making and communication frameworks.

To discuss any of the points raised in this article, contact your Account Manager on 0345 607 2013.

What to do next...

Watch a recording (right) of a webinar where Greg Davies of Oxford Risk discusses investing fundamentals and the crucial role of financial personality.

Note: We’ve uploaded this recording to YouTube for a smoother viewing experience, but have no control over any related content YouTube suggests alongside it.

You can also download our free white paper below expanding on the insights in this article.

This is part two of a four-part series for advisers on ‘managing investment risk in volatile markets’. Access part one here.

Next time in this series, we explore how multi-asset investing can help advisers and investors combat investment risk – and not necessarily in the way you might expect.

 


 

About the author

Greg B Davies PhD, Head of Behavioural Finance, Oxford Risk

Greg is a specialist in applied behavioural finance, decision science, impact investing, and financial wellbeing. He started the banking world’s first behavioural finance team at Barclays in 2006, which he led for a decade. In 2017 he joined Oxford Risk to lead the development of behavioural decision support software to help people make the best possible financial decisions.

Greg holds a PhD in Behavioural Decision Theory from Cambridge; has held academic affiliations at UCL, Imperial College, and Oxford; and is author of Behavioural Investment Management.

Greg is also Chair of Sound and Music, the UK’s national charity for new music, and the creator of Open Outcry, a ‘reality opera’ premiered in London in 2012, creating live performance from a functioning trading floor.

 


 

Past performance is not necessarily a guide to future performance and the value of investments (and any income from them) can go down, so an investor may get back less than the amount invested

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