Assessing a client's risk tolerance is critical to being able to help your clients construct an investment strategy and portfolio that meets their financial needs. However, assessing client risk tolerance is sometimes more complex than just asking your clients to describe the amount of risk they are comfortable with. Behavioral finance principles can help you better gauge a client's true tolerance based on a review of common biases, both cognitive and emotional, that affect an investor's ability to reach their goals.
There are twenty biases that are most commonly seen in investor behavior. These biases are unique to individuals, but can also be driven by market forces. For example, as the markets continue to recover, many investors are exhibiting the overconfidence bias, which can be described as an unwarranted faith in one's investing abilities. Investors susceptible to overconfidence bias often claim to be risk takers—willing to accept losses in the hopes of big gains. The reality, however, is that they often overestimate their own investing abilities as well as the precision of the data they are working with. As a result, they underestimate the downside risks to their portfolio. The confidence that such investors demonstrate is often driven by a desire to gain back losses and is usually short lived if they experience additional losses.