by The Financial Adviser’s Problem
There are two reasons why a financial adviser needs to measure an investor’s risk preferences. These have to do with the two ways that financial advisers add value for investors.
The first way an adviser adds value is to act as the agent for the investor, faithfully carrying out the investor’s wishes. Many investors don’t have the time or the proper tools to manage a portfolio by themselves, so they delegate the job to an adviser. In order to carry out the investor’s wishes, an adviser must have an understanding of the investor’s risk preferences.
The second way an adviser adds value is to improve the investor’s decisions. Investors may be financially unsophisticated, or subject to certain biases, as documented in Loos et al. (2014). By adding knowledge and subtracting emotion, advisers can improve investors’ portfolio choices.
More subtly, an investor may not be able to implement her own risk preferences when choosing a portfolio. An investor who avoids the stock market is avoiding both the risk of the market and the uncertainty of investing in an asset whose risk she does not fully understand. The “money doctor” hypothesis of Gennaioli, Shleifer, and Vishny (2015) states that trusted advisers may act to reassure investors that there is no hidden, unobserved source of risk, allowing investors to take on more risk (and thus earn higher returns) than they would on their own.
The investor’s inability to perfectly choose her own portfolio has two very important implications for financial advisers. First, it increases the importance of advisers, since they must find a portfolio that pleases an investor more than the one the investor would choose on his own. Second, it makes the adviser’s task more difficult, since the adviser cannot perfectly infer the investor’s preferences from his past decisions. The adviser therefore needs tools to better gauge the investor’s preferences. Financial advisers can measure investors’ preferences informally, through casual conversation, or formally, as with the quiz-type PMMs that have become more common in recent years. It stands to reason that more accurate and directly applicable measurements of financial risk preferences would allow advisers to better serve investors.
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1-Application of Preference Measurement: The Case of Riskalyze
By: Fangfei Dong; David Eil, PhD; Ethan Pew, PhD; and Noah Smith, PhD