Understanding risk aversion to support your clients better

“Be fearful when others are greedy. Be greedy when others are fearful.” This quote by Warren Buffet summarises his investment approach. For a financial advisor, it’s not always easy to get an idea about how a client sees investment. The best way is still to talk to them about their perception of financial risks. With this in mind, the following article presents a series of works on investment psychology. The aim is to shed light and provide tools for financial institution professionals. This data will enable you to consolidate your communication strategy and improve support to your clients. 

Psychology and investment: what does behavioural finance tell us? 

Seasoned investors know that emotions and finance rarely go well together. It’s the fault of cognitive bias, among other things. Therefore, the boom in digital solutions for personal finance is leading the media and professionals to examine the cognitive factors relating to investment. The ‘financial game and risk aversion theories’ were the first to describe these phenomena.  An example of this is FOMO (Fear of Missing Out on a good deal/investment) which is now used in everyday English. 

Behavioural finance is based on ‘micro’ research (works in social psychology) and ‘macro’ research (quantitative market analysis). This branch of behavioural economics has shed light on the characteristics inherent to psychology within the financial framework: 

• Cognitive bias linked to a distortion in processing information. This is associated with understanding (framing) or memory (anchorage). 
• Emotional bias (fears, desires, admiration and repulsion). 
• Automatic reflexes and habits. 
• Group or crowd mimicry. 
  
  

These behavioural phenomena have an influence on markets, in particular during extreme periods like bubbles or crashes. In this way, psychology highlights certain investment practices: 

• Excessive confidence: the investor overestimates their capabilities and the accuracy of the information they have. 
• Conservatism: the investor prioritises previous beliefs when faced with new information that contradicts these beliefs. 

• Availability: in this case, the person overestimates the probabilities linked to a recently observed event, due to memories that are still close in time. 
• Representation: when an investor assesses a situation by focusing on superficial characteristics instead of on probabilities. 
• Dependence on the framework: the form in which information is presented affects decision-making. 
  
  

The works of Richard Thaler and Daniel Khaneman have confirmed advances in behavioural finance. For financial institutions, these academic resources shed light on the individual and collective phenomena that affect their clients’ decisions.  

The objective for establishment is to create a knowledge base (relationship between personality types and investment) in an aim to develop tools (questionnaires and conversation techniques). This knowledge and these practices ultimately enable them to rely on risk assessment criteria. This is what we’ll see in the next paragraph. 

Understanding and explaining what risk is, to meet clients’ expectations 

What are the criteria to assess an investor’s relationship with risk? 

Traditionally, there are three methods of assessment available to financial institutions to appraise their clients’ risk tolerance: 

• Quantitative and objective measurements;  
• Psychological questionnaires; 
• Age-based assessments.  
  
  

Studies carried out over the past two decades indicate that age is not an essential criterion to determine an investor’s profile. In other words, an investor who is ‘aggressive’ at 30 may very well still be aggressive aged over 60. It’s an investor’s psychological profile that leads their decisions. 

Behavioural finance is therefore based on psychological assessment tools such as the MBTI (Myers Briggs Type Indicator) and the Big Five model. The latter describes five types of personality: 

• Openness (appreciation of new ideas, curiosity and imagination); 
• Conscientiousness (self-discipline, organisation and implementation of objectives); 
• Extroversion (tendency to seek stimulation and others’ company); 

• Agreeableness (tendency towards compassion and cooperation); 
• Neuroticism (tendency to feel unpleasant emotions). 
  
  

A large number of studies have established correlations between investors’ psychological traits and profiles. For example, a person with a high ‘openness’ and ‘extroversion’ score will tend to take more risks, unlike the ‘conscientiousness’ profile. 

Different psychological profiles, but similar decision-making in a fluctuating context 

Each client will have a specific relationship to risk. The whole challenge for an institution is to correctly assess this relationship to risk during the onboarding phase. 

However, beyond differences in profile, two characteristic behaviours are observed when there are strong market fluctuations: 

• Rising trend: individuals are enthusiastic and want to invest. 
• Falling trend: the feeling of fear predominates and pushes people to sell. 

These behavioural patterns do not help you put in place winning investment strategies in the long term. However, they are repeated with each stock market bubble or crash. The problem is that it’s difficult for individual investors not to respond to emotions such as fear or excessive confidence. 

The objective for a financial institution is therefore to offer a framework to guide investors in their decisions. 

Explaining risks, to give a realistic overview of an investment portfolio’s performance 

The financial sector has built its sales approach on the communication of figures concerning returns on investment. When a client envisages this figure in the long term, they imagine (in most cases) that the percentage made will be repeated to the nearest cent each year. They exempt likelihood or risk from their consideration. 

In this context, it’s opportune for a financial advisor to start a dialogue around risk. Psychological questionnaires help to situate the client's profile, in order to understand their behaviour better. For establishments proposing a digital investment solution to their client, quantitative questionnaires are also an asset. The data gathered can then be presented in visual content. For example, an animated and evolving graph enables the client to conceive - and anchor in their memory - the likelihood of a risk. In this way, they will be able to assess the consequences of an investment, whether they are positive or negative. 

In very concrete terms, a client who visualises an 8% return on investment with a downside risk of X% risk will be psychologically prepared if the event occurs.  In this sense, signposted communication, through several types of digital content (colour graphs, animation video, simulation on mobile) will enable your clients to gain a useful idea of the performance and risks relating to an investment portfolio. 

How do you communicate about risk to support your clients better? 

Starting a dialogue about an investment’s likelihood of risk should not be synonymous with stress or dissuasive predictions. On the contrary, it’s an exchange of information, enabling your client to appraise your institution’s expertise and professionalism. 

Firstly, clear communication is essential. For example, preparing a script can help move the conversation forward. The advisor can refine their script over time in order to make sure they mention all the points relating to risk in investment (depending on the client, some will have more importance than others). 

Another key element: asking as many questions as possible! In order to gather as much information as possible about your client, as well as to check that they don’t have any difficulty understanding. 

Last point - confirmation. At this stage, the client will have taken a position concerning the risks of one or more investments. Take the time to confirm each of their positions, to not leave room for doubt or ambiguity. 

A topic as central ask risk-taking requires several conversations in most cases. The conversations can progress according to a gradual roadmap: 

• First conversations: explain why the theme of risk is being highlighted. As a financial institution, you provide your client with expertise. You are therefore the best interlocutor to inform them about the risks relating to investment. A client will always be reassured by a professional who is able to explain risks through quantification and probability tools. They will also be more reassured to see that qualitative questionnaires can shed light on their decision-making. In this sense, the quality of information proposed (paper documents and digital solution) will be crucial. 
  
  

• When the conversation is more advanced: share what you think. Tell your client how you see their approach to the market and investment. You can mention the prospect of returns (and the related risks) in the short, medium and long term. If the discussion is already well established, the client will confirm or contradict your thoughts gradually. This is an excellent way to move forward towards costed models, with potential risks of X percent resulting in losses of X euros. Once again, don’t hesitate to ask your interlocutor to confirm their position, even several times if you think it’s necessary. 
  
  
• End the conversation with concrete data. Present several costed scenarios, with different risk hypotheses. For each level of performance that the client wants to reach, they will get a precise idea of the consequences in terms of risk. 
  
  

Last point - which is extremely important. Each client has a specific relationship to risk. Some clients can give precise answers quickly and confirm them without hesitating. Others will have much more difficult taking a position on different levels of risk. It’s essential to give a client as much time as necessary so that they feel that the conversation is based on listening and trust. In this perspective, the following questions will help your clients confirm their choices: 

• What spoke to you in this question? 
• You seemed enthusiastic about this answer, why is this in your opinion? 
• Why do you think this is the right decision? 
• What do you feel about this question? 
  
  

These are open questions that will help the client express themselves and then confirm their desire to take a position on a level of risk. 

💡 Client support:  

What do changes in the MiFID 1 and 2 directives indicate in light of market regulation and risk-taking in general? 

In 2007, MiFID 1 directive opened up the competition of the stock market trading venues. The 2008 crisis, however, revealed important weaknesses relating to a lack of liquidity, derivatives and opaque practices on non-official platforms. 

MiFID 2 arose from this observation. This revision of the MiFID 1 regulation was intended to fight grey areas in the markets and work towards better investor security. In this way, one of MiFID 2’s main objectives was to ensure that consumers precisely understood the nature of the financial products they wanted to invest in. 

The aim was that the products proposed be adapted to the client’s risk profile and their needs. With this in mind, the key points highlighted by the directive are the provision of clear information on the costs, charges and expenses relating to the investments (in the short and long term). Companies like Birdee enable financial institutions to offer financial solutions within the framework of the MiFID 2 directive. Institutions can thereby offer their clients a range of products enhanced by questionnaires throughout the onboarding process, in order to determine the different risk profiles in an intelligent way. 

Beyond the probabilities and quantifications, investment is built on human relations. Cognitive and social psychology helps financial institutions gain a better understanding of their clients’ decisions. It also enables them to improve listening and interactions with the latter. These are the keys for a constructive dialogue on the risks relating to investment. A brand capable of establishing this level of service will always be successful. In a digital economy focused on the ‘client experience’, the quality of interaction makes the whole difference.