Written by Melissa Grimshaw
Why do we need to complete a Risk Profile Questionnaire?
This is one of the most common questions that we are asked in our day-to-day working life as financial advisers/planners.
Why do I need to complete this questionnaire, why do you feel that you need to put me in a box?
Our answer: We are not trying to put anyone in a box, however, we do need a guide as to how well you will sleep at night when we place your hard-earned capital into the market.
I will attempt to explain without offending why the financial planning profession uses a risk profile questionnaire to help us understand your risk tolerance and your risk capacity.
Two jargon terms – Risk Tolerance – simply put – is the sleep test, and Risk Capacity – put simply, is how much risk you really need to take to meet your financial objectives.
The risk profile is a common tool that is used as a start, to identify a baseline for risk tolerance and risk capacity across the profession for investors.
Ultimately, investing is not just about numbers and financial trends, but also an understanding of human behaviours and the mind. How we think about investing – cognitive bias, vs how we feel about investing- emotional bias.
We can think rationally, but emotions can take over which may cause us to be irrational.
The overall concept falls into the arena of Behavioural Finance, where your financial planner needs to understand how you think and feel about money to formulate an investment strategy to match your risk tolerances and risk capacity.
This helps ensure your investment strategy is not disrupted too much with emotions, as markets rise and fall, to give the portfolio the best shot at reaching your objectives.
The actual risk profile questionnaire is generally used as tool in the first instance to gauge your overall risk tolerances. It provides us with a guide as to where you fall. Further understanding and conversations with you help us identify any biases that you may have as well. This all needs to be considered when constructing a portfolio that matches you and your needs best.
Your Investor Biases
Have you ever wondered what biases you may have when thinking about investing? Below I have listed a few more common key behavioral biases that may affect overall investment decisions.
Anchoring Bias – Whereby we place too much importance on the first piece of information we receive about an investment, like the price at which we bought a stock. For example, we purchased a stock for $50, the value drops to $30, tendency might be to wait until it returns to $50 to sell. But this isn’t always the best strategy, as it might never reach its original value again.
Herd Mentality – Ever felt tempted to buy into the latest “hot stock” because everyone else seems to be doing it? That is Herd Mentality, but remember, popularity doesn’t guarantee profitability. As many learned during the dot.com bubble of the late ‘90’s, following the crowd can sometimes lead to significant financial loss.
Did you Know – Dot.com Bubble – Between 1995 and its peak in March 2000, investments on the NASDAQ composite stock market index rose 800%, only to fall 740% from its peak by October 2002, giving up all its gains during the bubble.
Loss Aversion – We humans generally dislike losing more than we like winning. This can lead us to make investment decisions based on fear of losses rather than potential gains. For example, avoiding a great investment opportunity because its initial volatility makes you fear a loss, may prevent you from achieving longer-term gains.
Availability Bias and Recency Bias – We tend to base decisions on readily available information on recent events. For instance, if you hear news of a recent stock market drop, you might be inclined to sell out of fear, even if the overall long-term trend of the market is upward.
Overconfidence – Leads us to believe we can outperform the market based on our own intuition. An example of this might be excessive trading stocks believing that you have the “golden touch”, while, in reality, frequent trading often leads to subpar investment returns.
Recognising these behavioral biases can be the first step toward better financial decision-making. But it doesn’t stop there. Working with a financial planner can help you navigate these biases and maintain a disciplined approach to investing, tailored to your individual financial goals and risk tolerances.
We are here to guide you on your investment journey and help you avoid these common pitfalls. Let’s continue to learn, grow and build a solid financial future together.
Fun Fact – There are over 180 cognitive biases that have been discovered to date according to the Cognitive Bias CODEX.
Warren Buffet’s Teacher at Columbia University- Ben Graham, is famous for saying “The investor’s chief problem – and even his worst enemy – is likely to be himself”.
So next time your financial adviser asks you to complete a risk profile questionnaire or redo one every three years to test for any changes in your tolerances or when a major change in your situation occurs, you will understand the “Why” behind the request to complete the questionnaire.