Ch 3 Understanding a Client’s Risk Tolerance

Question 1

three principles dictate individuals’ economic decisions:

Answer 1

1. Perfect rationality
2. Perfect self-interest
3. Perfect information

Question 2

Homo economicus Strong Form

Answer 2

Irrational economic traits do not exist.

Question 3

Homo economicus Semi-Strong Form

Answer 3

There is an abnormally high occurrence of rational economic traits.

Question 4

Homo economicus Weak Form

Answer 4

Irrational economic traits exist but are not strong.

Question 5

three main types of Market anomalies

Answer 5

• Fundamental anomaly
• Technical anomaly
• Calendar anomaly

Question 6

successful advisory relationships share at least four fundamental characteristics:

Answer 6

1. The advisor understands the client’s financial goals.
2. The advisor uses a structured, consistent approach to advising
3. The advisor delivers what the client expects.
4. Both the client and the advisor benefit from the relationship.

Question 7

A client expects two main things from his or her advisor:

Answer 7

1. An understanding of their objectives

2. Investment returns consistent with their objectives

Question 8

Ambiguity Aversion

Answer 8

People avoid making an investment or taking risks when probability distributions seem uncertain to them, because they hesitate in situations of ambiguity.

Question 9

Endowment Bias

Answer 9

Pace more value on an asset they own than on one they do not own.

Question 10

Self-Control Bias

Answer 10

tendency to consume today at the expense of saving for tomorrow.

Question 11

Optimism Bias

Answer 11

People tend to rate themselves higher than the average for traits that are perceived as good

Question 12

three investor personality dimensions:

Answer 12

• Idealism versus Pragmatism (I vs. P)
• Framing versus Integrating (F vs. N)
• Reflecting versus Realism (T vs. R)

Question 13

FRAMING VERSUS INTEGRATING (F VS. N)

Answer 13

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.

Question 14

REFLECTING VERSUS REALISM (T VS. R)

Answer 14

Reflectors have difficulty living with the consequences of their decisions and taking action to rectify their behaviours.

Question 15

Best practical allocation

Answer 15

Adjusting levels of risk and returns to fit with the client’s behaviours

Question 16

two principles for creating a best practical allocation in light of client behavioural biases:

Answer 16

• Moderate biases in less wealthy clients; adapt to biases in wealthier ones.
• Moderate cognitive biases; adapt to emotional ones.

Question 17

Why should you moderate biases in less wealthy cllients?

Answer 17

if a biased allocation could put a client’s way of life at risk, an advisor’s best response is to moderate the bias

Question 18

5 drawbacks of a traditional risk tolerance questionnaire.

Answer 18

• 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.

Question 19

Common emotional biases

Answer 19

• Endowment
• Self-control
• Optimism
• Loss aversion
• Regret aversion
• Status quo