By Louis Williams, Head of Psychology and Behavioural Insights

Why do previously risk tolerant people panic and sell when faced with a significant portfolio loss? Such paradoxical behaviour has damaged both the overarching financial planning and investment process and also the adviser-client relationship, which lies at the heart of the industry. How might we help these investors?

First, we may have misconceptions around the cohort of ‘risk tolerant investors’. Their measured attitudes to risk reveal that they do not harbour negative beliefs concerning uncertainty in investment returns. As a result, we can perceive them as individuals who will not react negatively when faced with uncertain events. But should we draw such conclusions about them?

Risk tolerance is based on the degree of uncertainty an investor can handle. Therefore, risk tolerant investors are not immune to negative reactions. Whether these are emotional reactions, thoughts or actions, we should avoid having such high expectations of this cohort when faced with financial adversity.

Second, although attitudes to risk directly impact investors’ intentions, when faced with challenges, perceptions of their own abilities to overcome obstacles can intervene and lead them to act differently or not at all. A shift in focus is required.

To ensure investment suitability, investors must not only express their attitudes to risk, but they must be prepared for adversity in future. It is inevitable when we consider the cyclical nature of investment markets. Ultimately, advice firms want to observe consistencies between their clients’ attitude to risk and their behaviour when uncertainty, which we have witnessed during this year’s coronavirus crisis, arises. Therefore, it is naturally in firms’ and their clients’ own interests to encourage and develop resilience.

Confidence can be key to greater resilience

Resilience relates to bouncing back from difficult periods, but also an ability to adapt in the face of such adversity. However, what might make someone financially resilient today could be removed from what makes them emotionally resilient.

Financial resilience is said to be heightened by having more resources, social connections and sector knowledge. However, more emphasis must arguably be placed on people’s characteristics to reach a fuller understanding. For example, traits of optimism and emotional stability point to someone being more resilient – and encouraging investors to build resilience is important, while extra resources can, of course, be created to assist here particularly for times of adversity.

At Dynamic Planner, in the lockdown, we created and launched a new ‘Content Hub’ on our website, allowing anyone to visit and download free material to help support thinking around the value of remaining invested long-term.

A belief in one’s own ability to manage their finances, known as financial self-efficacy, is a key component of their resilience during periods of uncertainty. Recently, academic research has provided empirical evidence indicating that those with high levels of financial self-efficacy are more willing to keep faith with assets which have suffered a fall in value.

For individuals with a low level of financial self-efficacy, market volatility has been found to negatively impact them and they are viewed to be less resilient against this backdrop. Research has further suggested that it is possible for someone to be highly risk tolerant, yet equally respond poorly to market volatility, if they lack faith in their own ability to manage their finances.

Cash flow planning and the big picture

Advice firms have a responsibility, in a sense, to foster their clients’ resilience. Communication of course is key, through the development over time of strong relationships with clients and by effectively articulating the pitfalls of buying and selling investments at bad times, by encouraging clients through periods of market volatility, and by highlighting the importance of long-term investing. Furthermore, it naturally is also important for firms to be aware of their clients’ current emotional state and fears, particularly in times we have experienced in 2020.

One way in which Dynamic Planner enables end clients of firms to develop resilience is by accurately informing them how the value of their pensions and investments will last during their retirement, when most people will use them to draw a regular income.

Cash flow modelling and planning enables clients, of course, to powerfully visualise their overall financial outlook and situation – and in different scenarios. For example, if they enjoyed a higher or a lower level of income, or if they took a higher level of risk with their portfolio. Knowledge is power, here, enabling end clients to feel informed and hopefully confident about their prospects and situation later in life.

In conclusion

How can we help advice firms understand their clients’ level of financial resilience? Dynamic Planner currently incorporates emotional-based statements within the attitude to risk questionnaire, which can be further employed to reveal someone’s emotional resilience to withstand a loss. Further research is now being conducted to develop an explicit measure of financial resilience.

In addition, it is important to inform firms about how clients think they will act versus how actual data tells us they will act. Dynamic Planner gathers responses from end clients on previous decisions they have reached when investments have substantially fallen. This of course can signpost red flags and trends of anxious behaviour during times of adversity.

Inconsistencies between risk appetite and the reality when investments significantly fall in value is a serious issue and one which has its challenges. Helping advice firms support their clients – by managing their wealth and developing their resilience – can only further ensure investment suitability and ultimately strongly encourage people stay invested at points in their journey when it may be most tempting to bail out.

If you are not already a Dynamic Planner user – and would like to find out more about how we can help you and your firm – please get in touch.