Ch 3 Understanding a Client’s Risk Tolerance Flashcards
three principles dictate individuals’ economic decisions:
- Perfect rationality
- Perfect self-interest
- Perfect information
Homo economicus Strong Form
Irrational economic traits do not exist.
Homo economicus Semi-Strong Form
There is an abnormally high occurrence of rational economic traits.
Homo economicus Weak Form
Irrational economic traits exist but are not strong.
three main types of Market anomalies
- Fundamental anomaly
- Technical anomaly
- Calendar anomaly
successful advisory relationships share at least four fundamental characteristics:
- The advisor understands the client’s financial goals.
- The advisor uses a structured, consistent approach to advising
- The advisor delivers what the client expects.
- Both the client and the advisor benefit from the relationship.
A client expects two main things from his or her advisor:
- An understanding of their objectives
2. Investment returns consistent with their objectives
Ambiguity Aversion
People avoid making an investment or taking risks when probability distributions seem uncertain to them, because they hesitate in situations of ambiguity.
Endowment Bias
Pace more value on an asset they own than on one they do not own.
Self-Control Bias
tendency to consume today at the expense of saving for tomorrow.
Optimism Bias
People tend to rate themselves higher than the average for traits that are perceived as good
three investor personality dimensions:
- Idealism versus Pragmatism (I vs. P)
- Framing versus Integrating (F vs. N)
- Reflecting versus Realism (T vs. R)
FRAMING VERSUS INTEGRATING (F VS. N)
Framers tend to evaluate their investments individually and do not consider how each of them fits into an overall portfolio plan. Integrators view the individual within the whole.
REFLECTING VERSUS REALISM (T VS. R)
Reflectors have difficulty living with the consequences of their decisions and taking action to rectify their behaviours.
Best practical allocation
Adjusting levels of risk and returns to fit with the client’s behaviours
two principles for creating a best practical allocation in light of client behavioural biases:
- Moderate biases in less wealthy clients; adapt to biases in wealthier ones.
- Moderate cognitive biases; adapt to emotional ones.
Why should you moderate biases in less wealthy cllients?
if a biased allocation could put a client’s way of life at risk, an advisor’s best response is to moderate the bias
5 drawbacks of a traditional risk tolerance questionnaire.
- Fails biased individuals.
- Generates different results when given in different formats to the same investor.
- Given at the beginning of the relationship and never revisited.
- Advisors interpret the results too literally.
- Framing bias can be present in how the questions are designed.
Common emotional biases
- Endowment
- Self-control
- Optimism
- Loss aversion
- Regret aversion
- Status quo
