BEHAVIOURISK DETERMINES YOUR BEHAVIOUR INVESTMENT PROFILE AND CORRECTS YOUR INVESTING MISTAKES

Risk profiling seeks to establish a client’s risk tolerance, i.e., the maximum amount of risk he can comfortably manage. Risk tolerance then serves as a guide to which products he should be sold.

Standard risk profiling focuses on quantitative aspects (investing experience, time horizon, personal assets and liabilities etc.). Behavioural investment profiling enhances standard risk profiling and focuses on qualitative or psychological aspects described in terms of the presence of cognitive and emotional biases and their degree.

Standard risk profiling classifies a person as highly risk tolerant, i.e., can manage high volumes and wide varieties of risk, if he is young, has extensive experience as an active investor, has invested in different asset classes, has a long investment horizon, follows financial markets news, has a degree in economics or finance, and, most importantly, has enough wealth outside of his brokerage account to withstand significant drawdowns.

Behavioural investment profiling confirms that a person is highly risk tolerant when he has no cognitive or emotional biases, or these are of a limited nature, i.e., this person is capable of consistently making rational decisions and is free of unwarranted emotions (like Mr Spock).

Both are essential. One cannot (and must not) rely only on quantitative aspects without considering qualitative aspects, and vice versa. An intelligent, risk-aware investor should take into account both standard risk profiling (quantitative) and behavioural investment profiling (qualitative)

Behavioural investment profiling in the finance industry has existed for several decades. There are three reasons it has not become widespread:

Conflict of interest among investment firms If executed correctly, i.e., covering all investing biases and using science-validated approaches, behavioural investment profiling typically reveals that individual investors have many risk and investment decision-making irrationalities. This may imply low true risk tolerance. Standard risk profiling, which is easy to manipulate, produces much higher risk tolerance categories for the same clients. In the finance industry, low risk tolerance means that the investment firm should offer only low-risk products to the respective client. However, the higher the product’s risk, the greater the profit that can be earned selling it. Conducting behavioural investment profiling for every client would mean lower average risk tolerance and, consequently, lower investment firm profits. Financial regulators worldwide, including SEC, FCA, and ESMA, have been fighting conflicts of interest and mis-selling (when a firm sells unsuitable, usually higher-risk, financial products to its clients to earn more) among investment firms for many years. However, to date, the consensus solution remains standard risk profiling, which, as we know, is incomplete and misleading because it ignores the client’s unique risk behaviour.

Some investment firms offer behavioural investment profiling but only to selected premium clients (e.g., private banking with $50mn+ accounts). These clients are very valuable to investment firms and they don’t want to lose them. To ensure complete client satisfaction and avoid any possible mistakes, investment firms offer premium clients many VIP services, including behavioural investment profiling.

Proper behavioural investment profiling involves additional costs – creating and validating questionnaires, explaining the benefits of the new service, administering the process, changing asset management operations, and so on. In any business, if the extra effort and cost are not legally required and do not result in commensurate extra profits, they are unlikely to be undertaken.

You are correct. Behavioural economists and psychologists have determined over 200 different biases. BehaviouRisk focuses on 19 for the following reasons:

Behavioural economics as a science covers every economic aspect of our lives, whereas behavioural finance, a subfield of behavioural economics, focuses on human behaviour in the financial markets only. Therefore, fewer biases are relevant to investing.

Different names have often been assigned to identical or very similar behavioural patterns. BehaviouRisk combines several closely related ideas for the purposes of simplification and time.

BehaviouRisk focuses only on those with the most considerable negative effect on individual investors.

The result is the 19 most relevant and critical behavioural patterns.

It is very common and perfectly acceptable to have biases. Even professionals are prone to some!

We have analysed thousands of client cases, ranging from newcomers to professional traders, and we know it is common and perfectly acceptable to have biases. The number or degree of your biases do not make you a bad or a good investor. Rather, the identified biases indicate which potentially detrimental behavioural patterns need your attention. What distinguishes a genuinely risk-aware investor is a readiness to honestly acknowledge one’s own biases, seek the knowledge required to overcome them, and then have the discipline to apply this knowledge.

Professional traders are also human and thus are also prone to some biases although seasoned professionals have fewer cognitive biases thanks to experience. Emotional biases are more difficult because these are driven by personality traits, which are much harder to change. Emotional biases require permanent discipline and control in addition to awareness. Trained professionals accumulate good self-control skills over time, which alleviate the influence of emotional biases, although they frequently fall into the overconfidence trap fostered by extensive experience. Importantly, top investment firms have secret weapons in the form of risk IT systems designed to monitor all varieties of risk and quickly correct traders’ losing behavioural patterns.

The good news is that you can overcome biases, especially if you are equipped with risk IT solutions. However, it takes some effort and learning although we prefer to think of it as an investment in yourself, one of the greatest investments you can make.

Cognitive biases, i.e., mistakes in thinking, can be effectively eradicated by education, such as the advice in your BehaviouRisk personalised report or our book, Practical Behavioural Finance for Risk-Aware Investors. However, emotional biases, i.e., errors in emotional reactions, are more difficult to overcome and require permanent discipline and control in addition to awareness, although the advice from the report and the book will once again prove tremendously helpful. Optimally, you should use a risk IT solution such as PRAAMS to obtain bias-free, professional, and complete advice.