It’s tempting to equate financial risk taking with general risk taking, as it seems to make intuitive sense. But the two are not the same, and it is dangerous for advisors to treat them as if they are.
There are different types, or ‘domains’, of risk. Some of the common domains in risk models include:
- Physical risks – things that can result in physical harm, like driving race cars, scuba-diving or smoking cigarettes. At worst, life can be lost.
- Social risks – things that can result in a loss of self-esteem or respect, such as public speaking. At worst, ‘face’ can be lost.
- Ethical risks – things that can carry penalties for a breach of moral, religious, or legal standards such as being caught in an extramarital affair or a theft. At worst, our internal integrity is undermined.
- Monetary risks – things that can result in the loss of money such as a bad investment or gambling. At worst, the roof over our heads and food on our tables can be lost.
The ongoing question, and debate, has been what one domain of risk can tell us about another. Is a smoker also likely to take ethical risks? Is a bungee-jumper likely to accept more investment risk than a non-jumper? Is a racing car driver also likely to participate in public-speaking?
There’s a lot of scientific evidence to say that these risk domains are quite separate, and largely unrelated. Nonetheless, several studies have tried to identify, what they believe to be, consistency across the different domains. So how are we to reconcile these apparently opposite views?
Part of the answer is that statistics and real-life are often different. The people who identify consistencies tend to find them only in a statistical sense- which does not, generally, explain the differences in risk-taking behaviors between different people.
Another part of the answer lies in the ‘nature versus nurture’ debate. There may some truth to the hypothesis that different people’s genetic makeup influences their general, or broad, risk preferences, but at the same time, we know that environment plays at least an equal part – and often dominates any genetic pre-disposition.
For these reasons, it is entirely consistent that two people with the same ‘general’ risk tolerance could have dramatically different financial risk tolerances, due to their different life-experiences.
Perhaps the best example is the children of the Great Depression which began in 1929. For most of their lives, many saved pieces of string and paper and avoided debt at all costs – their world view of money had been inexorably shaped by the harsh childhood in which they grew up. But some of them still drove very quickly, jumped out of planes and sang in public! Their risk-taking in those domains was often quite different.
The lesson for financial advisors is that we can’t simply extrapolate risk-taking in one domain across to another. At times it could be accurate – but often it will be inaccurate. It is still necessary to specifically measure financial risk tolerance.
Read more here: Is Risk Tolerance a General Trait or Is It Domain Specific?