Behavioral Finance for Private Banking, 2nd Edition

CHAPTER 10Risk Profiling

This chapter combines all insights of behavioral finance that we laid out previously. In the first chapter, we explained which typical behavioral biases hinder investors to achieve the best possible performance. As we showed, a diagnostic tool helps detecting those biases and suggests ways moderating them. Thereafter, we laid the foundation for this chapter by outlining the most up‐to‐date decision theory: prospect theory. Given all this the advisor must recommend an asset allocation that yields the optimal combination of reward and risk and that the client can hold through during the ups and downs of the markets. As the study of Brinson, Hood, & Beebower (1995) and Brinson, Singer, & Beebower (1991) have shown, the asset allocation determines 90% of the investment success—but to achieve this success the investors must also be able to hold through the strategy. Thus, risk profiling is one of the key elements of investment advice. Besides this important conceptual aspect of risk profiling it is also important for legal reasons. In a sense, risk‐profiling means that the advisor and the client write a contract that protects both sides if a dispute arises sometime later. Finally, in some countries the regulator requires using a risk profiler that satisfies some minimal standards and in some countries the regulator might even mystery shop to check whether a risk profiler is used appropriately in the advisory process.¹

Used appropriately, risk profiling ...