How advisors' risk preferences can shape client portfolios - For better or for worse

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🧠 Risk Perception: A Subjective Phenomenon

It's no secret that everyone perceives risk differently. Even with the same figures and data, people interpret risk uniquely, which shapes how they talk about opportunities and threats. From a market perspective, this diversity in risk perception is perfectly natural - it fuels different investment behaviors and animates the financial ecosystem.

⚖️ The Financial Advice Dilemma

However, when it comes to financial advice, the story changes. Regulations clearly state that advisors must tailor their advice to align with their clients' specific risk tolerance. Yet, research shows that financial advisors' personal risk preferences can influence the advice they give.

🔍 Mechanisms of Influence

1. Projection Bias

Advisors tend to unconsciously project their own risk preferences onto their clients. An advisor with a strong aversion to risk may recommend more conservative portfolios, even to clients with a higher risk tolerance. This projection can create a "one-size-fits-all" problem where an advisor's portfolio becomes a mirror image of their clients'.

2. Anchoring Effect

The advisor's risk preferences can serve as an anchor point during discussions with the client, subtly influencing the latter's choices. This anchoring can steer the conversation and decisions towards the advisor's preferred risk level.

Learn more about cognitive biases

3. Product Selection

Advisors may favor financial products that align with their own risk tolerance, thereby limiting the options presented to clients. This practice is particularly concerning within institutions like banks, where financial products offered are tied to the bank's profit margins (Hoechle et al., 2018).

4. Interpretation of Client Objectives

The advisor's risk aversion or appetite can influence their interpretation of the client's financial goals. This biased interpretation can lead to recommendations that don't truly match the client's needs and objectives.

5. Risk Communication

The way an advisor presents and explains risks can be colored by their own preferences. A more risk-inclined advisor might downplay certain risks, while a more conservative advisor might emphasize them.

6. Portfolio Rebalancing

Rebalancing decisions may be influenced by the advisor's risk perception rather than the client's actual needs. This can result in portfolio adjustments that are not optimal for the client.

7. Confirmation Bias

Advisors may seek information that confirms their own views on risk, neglecting contradictory data. This bias can reinforce their existing risk preferences and further influence their recommendations.

📊 Empirical Evidence

Empirical studies support these observations. For example, Foerster et al. (2017) found that many advisors tend to recommend similar asset allocations regardless of their clients' actual risk profiles.

Even worse, advisors may inadvertently reinforce their clients' existing biases, rather than helping them overcome them (Mullainathan et al., 2012). This can be influenced by the advisor's own risk perceptions, further complicating the objectivity of financial advice.

🖼️ Nuancing the Picture

It's important to emphasize that not all advisors fall into these patterns. Many provide invaluable advice, especially for those with less financial knowledge. However, the evidence highlights a critical point: advisors, in some cases, may let their own risk preferences shape their recommendations - potentially moving clients away from their true objectives and risk tolerance.

💡 Solutions and Perspectives*

To mitigate these biases, several approaches can be considered:

1. Advisor Training: It's crucial that advisors are trained to recognize their own risk preferences and separate them from those of their clients.

2. Standardized Tools: Standardized risk assessment tools and structured recommendation processes can help reduce the influence of personal biases.

3. Transparency: Encourage greater transparency in the advising process, clearly explaining the reasons behind each recommendation.

4. Technology and AI: The use of technology, such as AI financial advisors, can offer a more objective approach. For example, LiLa, Odonatech's AI financial advisor, has no personal risk preferences. It follows a consistent investment philosophy centered on long-term growth and helps people create meaning with their money. Its advice is objective and entirely based on the individual client's goals and risk tolerance - eliminating the risk of human bias.

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Conclusion

Understanding the impact of advisors' risk preferences on client portfolios is crucial for improving the quality of financial advice. By recognizing these potential biases and implementing measures to mitigate them, the financial advisory industry can better serve its clients and help them achieve their true financial goals.

References

Foerster, S., Linnainmaa, J. T., Melzer, B. T., & Previtero, A. (2017). Retail financial advice: Does one size fit all? The Journal of Finance, 72(4), 1441-1482.

Hoechle, D., Ruenzi, S., Schaub, N., & Schmid, M. (2018). Financial advice and bank profits. The Review of Financial Studies, 31(11), 4447-4492

Mullainathan, S., Noeth, M., & Schoar, A. (2012). The market for financial advice: An audit study (No. w17929). National Bureau of Economic Research.