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Why risk assessment surveys are flawed
Dani Fava, 05/01/2019
Director, Product Strategy & Development, TD Ameritrade Institutional
In a fascinating book titled, Everybody Lies by Seth Stephens-Davidowitz, we learn about our proclivity for being untruthful.
For one, when University of Maryland alumni were surveyed, 2% admitted that they graduated with a GPA of less than 2.5—in reality the number was closer to 11%. Whether we're inflating our capacity for doing good, or downplaying our seduction by evil, we're always inclined to make ourselves look better.
Davidowitz argues that especially when answering a survey, we're motivated to skew the results. This behavior is called social desirability bias, and it happens whether the survey is anonymous or not.
So, how does this phenomenon manifest in financial services and why does it matter?
Well, almost every financial advisor I know bases a client's portfolio on a few key factors: one of them being their appetite for risk. But the way they collect that risk—via a survey —is fundamentally flawed for a number of reasons.
I'll explain three of those reasons here, starting with reason number one: Everybody lies.
|1.||Everybody lies. Think about the scenario... You're engaging in a new relationship with a financial advisor. No doubt she is there to help you, but still, you want to appear tough, resilient, and smart. You want her to think you're going to be a good client as much as she wants you to think she's going to be a good advisor. On your second meeting she administers a survey that asks how you would react in a bear market. She says there is no “right" answer, but you still feel like you don't want to appear sheepish or unrealistic. So, you increase your tolerance for risk ever so slightly within your answers.|
|2.||Risk tolerance doesn't matter in times of market upheaval. Most financial advisors assess their clients through a Risk Tolerance Questionnaire, or RTQ. But, this gives little insight into a person's behavior during a market melt-down. As described by Dr. Daniel Crosby in The Behavioral Investor, risk tolerance is defined as your static, long term attitude about risk, but risk perception is the dynamic, contextual piece more likely to fluctuate during periods of market upheaval.1 Therefore, your risk perception, which drives your risk taking behavior and actions, is an adaptive system and it changes with your circumstance and with the market environment. But, a static RTQ is given at a point in time, without any emotional tie to real money. The science shows that there is little correlation between financial decisions made on paper versus ones made in real life. In the end, as Dr. Daniel Crosby explains, risk-taking behavior is all that matters and the fact remains that it is changeable and context-dependent. But, most advisors don't measure risk on an ongoing basis. Or, most RTQ processes are simply unable to.|
|3.||Even if you're not a liar, it's literally impossible to tell the truth. Let's say you're completely honest and self-aware and have no desire to paint yourself in a favorable light. You intend to answer the survey as truthfully as humanly possible. Well, you can't. Why? Because when you answer the survey you're not under any stress. At least, you're not under the kind of stress that seeing your retirement savings fall 20% in value would cause. The truth is, you don't know how you're going to react in that situation. So even with your good intentions, and your super-human truth telling capacity, you're going to “lie." (Even though you can claim plausible deniability later.)|
So, what now? Are advisors doing the wrong thing by administering these surveys? Absolutely not. They are responsibly using one of the only tools that are available. It's the tools themselves that need to evolve—and they should evolve by using the vast amounts of data that are available.
Beyond proving that we're all liars, the main point of Everybody Lies is to display the power of data.
Davidowitz focuses on Google analytics and what information we can glean from anonymous search data. Anonymous search data won't help financial advisors in this capacity, but other data will. Think about the behavioral paper trail that you've left online. Let's call theses breadcrumbs.
There are breadcrumbs in the way that you spend, the way that you pay your debt, the way you vacation, spend your leisurely time, how often you share on social media, what you share on social media, the kind of vehicle you drive, how fast you drive it, and so on.
Although, it is generally believed that risk-taking behavior is domain specific and how fast you drive your car has little indication on how you will manage your finances, there are still a lot of finance-specific breadcrumbs in the data set.
As a matter of fact, with the right data, we can probably see how you reacted during the last market downturn: Did you reallocate your 401k? How many times did you log into your account to check your balance? Did you change your spending habits during the same time?
If we could access all of THIS data on an ongoing basis, we could, perhaps, come up with a much more accurate measurement of risk appetite, and a much better understanding of your specific needs as a client.
Of course, this is a tall order and may be a long ways away. But for the moment, my advice to financial advisors is to put little weight into the outcome of a risk analysis survey and instead rely on what you know and what you observe about your client.
If the outcome of their risk survey says they're aggressive, but they've been sitting in bonds in their 401k and call you every time an economic indicator has a poor showing… reserve the right to draw your own conclusions. And, keep your head up for better risk measurement solutions that may emerge.
1. Crosby, The Behavioral Investor
TD Ameritrade, Inc. and the mentioned third parties are separate and unaffiliated and are not responsible for each other's services or policies.
Content provided is for educational purposes only and is not intended to be advice for any firm.
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