Ryan Murphy MICUS
Ryan Murphy

Morningstar Seeks to Reinvent Risk Tolerance Tools

Most questionnaires advisors use to measure their clients aversion to loss are close to “useless” and don’t take into account a client’s biggest risk: Their own behavior.

Morningstar’s Director of Behavioral Science, Ryan Murphy, told a room of financial advisors at the research firm’s annual conference that most of the risk tolerance tools they use to help guide a client's investment plan are very close to useless. 

Murphy asked attendees if they had a choice between receiving $50 with certainty, or flipping a coin and taking the chance of receiving $100, which would they choose?

At least half the crowd in the room would choose the guaranteed $50. But as the assured gain was lowered, the enthusiasm for the safe choice waned. “People have risk aversion,” Murphy said. “It’s hardwired into them.”

The thing most questionnaires miss is that risk tolerance is a dynamic thing, it changes over time according to circumstances, and often doesn’t take into account that sometimes the greatest risk to a client comes from the client themselves.

Instead of just focusing on risk-aversion, Murphy and his colleagues have been working on what they call a "goals-based" risk analysis tool, using findings in behavioral finance as the framework. 

It accounts for loss tolerance, but through the lens of client goals and behavior. Selling an investment at the wrong time is the kind of self-defeating behavior that costs investors as much as one to two and a half percent a year, according to Morningstar research.

Murphy said his view of risk profiling would lead advisors to act as “behavioral coaches” who do more than create a financial plan. More effort should be spent building their clients’ resilience to the ebb and flow of returns and keep them from self-destructive investment behaviors.

For clients who already have high “resilience risk,” that might mean they don’t need much reassurance or contact. For others, an advisor acting as a good behavioral coach might proactively reach out to clients in times of market stress. One investor might be fine with the value of the portfolio fluctuating over time, as long as it is growing in the long run. Others might not be as comfortable when that scenario so they might choose to save more.

The end result of the risk-analysis tool, which will be available in Morningstar’s advisor platform in the future, is to help advisors act as counselors to their clients more than investment managers. As investment management becomes cheap and commoditized, an advisors value becomes not how to match a portfolio to a client’s risk tolerance. It’s knowing how to keep clients from being their own worst enemies.

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