Managing Your Clients’ Risk Perception

Managing Your Clients’ Risk Perception

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Managing Your Clients’ Risk Perception

by Commonwealth Financial Network

When the market heads up or down precipitously, managing your clients’ risk perception is key. But to do so, you must first understand the difference between risk tolerance and risk perception.

In a nutshell, the reason why people’s risk tolerance can be drastically different from their reactions in times of fear or greed has to do with this notion called risk perception. Research shows that risk tolerance is a fairly stable “personality trait”—something that stays the same about people unless they have a life-changing experience. Risk perception, on the other hand, is an emotional state, which can come and go fairly quickly.

To illustrate the difference between risk tolerance and risk perception, let’s use 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, you drive as carefully as possible because your mind is overestimating the risk. Of course, you’re the same person you were 10 minutes ago (your risk tolerance). But in the face of almost running off the road, the awareness you have of the danger (your risk perception) has skyrocketed.

So, while interrelated, risk tolerance and risk perception are fundamentally different things and are best handled differently. In my view, one’s objectives, capacity, and tolerance for risk should drive one’s investment strategy. But risk perception is best managed through client education, along with occasional crisis management.

Reintroduce the concept. Given the length of the current bull market, now is the perfect time to introduce or reinforce the notion of risk perception. With my clients, for example, I share the car analogy. It’s an effective way to let them know that risk perception—while real in the emotions it produces—causes us to inflate the true danger we’re facing and can provoke poor decision-making.

I ask clients if they’ve experienced this kind of thing in their investing lives and what action they took. If they show signs of regretting a previous action, I ask them what they’d want to do in the future and how they’d like me to help them stick to that choice. For some clients, this is enough.

Share strategies. For other clients, I ask what strategies they’ll use in those moments of panic. If they don’t have productive ideas, I might suggest the following: 

  • Go on a news diet by tuning out the radio stations, TV channels, and websites that cause panic for them.
  • Dive deeper into a hobby.
  • Call me to rerun a financial plan to see how the market action has changed their projections.

Too much versus too little. It’s important to keep in mind that when the market is too good for too long, risk perception can fall below a productive level. This can cause clients to want to move into a more aggressive allocation than their true needs or risk tolerance would suggest is warranted. This tendency can be part of the same education.

Let’s revisit the car analogy: When we’re on a long, quiet stretch of highway that we drive frequently, we relax. In those moments, we underestimate the risk and may speed, read a text, or otherwise put ourselves in more danger than we normally would. In bull markets, we tend to do the same thing. We see everyone else making more money, and we get less fearful and have an impulse to push our allocation toward more risky assets.

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