Risk tolerance, risk profile, risk appetite, risk capacity… what are the differences?
In financial theories, financial risk is a mathematical number, like volatility, that determines the level uncertainty (potential gains and losses) of an investment.
If you want to win more, you have to take more financial risk. If you want to minimize your losses, you have to take less financial risk. Your investment return will be lower.
Aggressive investors take high risks in the hope of a higher return. Conservative investors prefer to avoid losses and minimize their investment risk.
The quantification of the risk bearing capacity of an investor, and the level of risk required in his investments, is commonly termed the risk profile.
There are other terms like “risk tolerance profile”, “risk aversion”, “risk appetite” which are often confused with risk profiles. But unlike risk profiling, risk tolerance profile or risk appetite corresponds to how much risk an investor is willing to take, without taking into account his capacity to bear risks (risk capacity).
To conclude, a risk profile is a combination of risk tolerance (willingness to take risk) and risk capacity (capacity to bear risk).
What is a risk profiling process and how it is used by financial advisors?
Risk profiling is a process that a financial advisor uses to help determine the optimal level of investment risk for his clients.
Since clients’ risk profile and risk tolerance profile are not stable in time (affected by the investor’s age, change of job, new family situation…), the risk profiles should be updated every few year by the financial advisor.
Assessing client’s risk tolerance is compulsory for financial advisors in most countries.
How are risk profiles traditionally assessed?
Risk profiling is usually done in the form of a paper or digital questionnaire which is constructed internally by the financial institution or the financial advisor.
Generally, each question corresponds to a number of points (example: 1 point for a senior client and 5 for a younger client) which are added to compute a final risk profile score.
Based on this score, a risk profile is assessed, generally in 3 or 5 categories (from very conservative to very aggressive). Each risk profile category corresponds to a specific investment or portfolio risk.
Based on a PwC report, 80% of financial institutions were still constructing their risk profiling process internally in 2016. The scientific validity of this kind of questionnaires is rarely tested by financial institutions.
How can behavioral finance improve the risk-profiling process?
What is behavioral finance?
Behavioral finance is an academic field that emerged in the XXth century and whose objective is to model the psychology of the investor. This science has been rewarded by four Nobel Prizes and is a growing field of the financial academic literature.
The starting point of behavioral finance is the irrationality of the investors. Contrary to what is supposed by traditional financial theories, most investors are affected by cognitive biases which strongly influence their financial decisions, including their risk aversion.
Optical illusion is an example of cognitive bias which affects our perception. There are similar biases which directly affect our financial decisions, like loss aversion, uncertainty bias or herding effect.
What are the cognitive biases which affect our risk profile?
Loss aversion
Let’s imagine you can invest in a bet with a 50% chance of getting either $100 or $0, or get $50 for sure. What do you prefer?
Most investors are risk averse and prefer the safe option of $50.
Now, what if I asked you to choose between paying $50, and placing a bet where you have 50% chance of paying either $100 or nothing?
In this case, most investors prefer to gamble. There is some hope not to lose. We try our chances.
Most investors are afraid of losing. On average, we are twice more sensitive to losses than to gains. Loss aversion is one of the most fundamental heuristics in our financial decisions.
Sensitivity to gains and losses
Moreover, we are much more sensitive to a change in small losses than in big losses. If you expected to pay $10 for your meal and get a $20 bill, you may become terribly upset. But if you finally buy your house $1.1M instead of $1M, it may not really matter.
Probability perception
We are also more or less optimistic or confident in our financial decisions. If you drive a car for the first time and are told that 1M+ people die each year on the road, you may be quite scared and overestimate the probability of crashing. If you are an experienced driver, you may on the contrary be overconfident and underestimate the risk. Our perception of probabilities is biased by heuristics such as overconfidence, optimism or uncertainty aversion.
Prospect Theory
These cognitive biases are not taken into account in traditional financial theories even though they highly influence the client’s risk tolerance. They are however in the core of many behavioral finance theories.
One of the most famous one, Prospect Theory, is a decision-making model under risk which includes these psychological factors.
Developed by the Nobel Prize winners Daniel Kahneman and Amos Tversky in 1979, Prospect Theory models these three cognitive biases by a mathematical utility function and probability weighting function with 4 parameters: sensitivity to gains and losses, loss aversion, optimism and likelihood sensitivity.
These two functions can be ultimately transformed into a volatility to recommend investment portfolio and products.
The Prospect Theory has been constructed based on multiple economic experiments with real investors worldwide. It is now the reference in more than one million academic publications and represents a very accurate way to predict investor risk tolerance, by comparison to traditional risk profiling questionnaires used by most financial institutions.
How is Neuroprofiler using behavioral finance for risk tolerance assessment?
In order to help financial advisors have a deeper understanding of their client’s cognitive biases and suitable investment risk, Neuroprofiler has developed InvestProfiler, a behavioral finance game to assess their client’s risk tolerance based on Prospect Theory.
The InvestProfiler can be used to recommend suitable financial products to clients, in line with their risk tolerance, but also for lead generation and marketing campaigns.
It lasts from 2 to 3 minutes and is completely adaptive. Each question depends on the answer to the previous question. More than 100 risk tolerance levels can be assessed, with a predictability rate of 80% for risk tolerance, vs. 10% for traditional risk-profiling questionnaires.
It is very flexible in terms of integration and customization. It can be used with an i-frame, an API or a web application, with or without IT integration. We offer more than 40 different designs for the game to address all types of clients, from senior High Net Worth Individuals to Millennials. The solution is fully responsive and can be used with a smartphone, tablet or PC.
If you want to know more about our behavioral finance risk tolerance assessment approach and our InvestProfiler, do not hesitate to contact us at contact@neuroprofiler.com.