Risk Literacy And Understanding Real Investment Risks


Executive Summary

The concept of “risk literacy” may be new to financial advisors, but it is not a new construct. In fact, risk literacy – or the ability to understand the probabilities of risk and internalize them to make a good decision – has been applied in the context of the behavioral sciences for years. Thus, why it is so common now to talk about the risks of a medical procedure in terms of the mortality or survival rates… so people can make a good decision with a thorough understanding of the risks involved.

Except the challenge of risk literacy is that not everyone truly understands probabilistic risks. Which is concerning not only in the world of medicine, but also financial advice. Especially with the rising popularity of econometric-style risk tolerance questionnaires that ask investors to choose from a series of probability-based trade-offs… without first clarifying whether the investor even truly understands how to weigh those trade-offs. Or similarly, making a decision about which strategy to pursue for retirement based on the Monte Carlo probabilities of success (that, again, not all prospective retirees may really have the risk literacy to understand properly).

The good news, though, is that it turns out risk literacy can be taught. It is a function of financial education, and investors can be helped to make better decisions with a supporting explanation and education about the probabilities. Which helps to ensure that investors or prospective retirees really are considering the odds properly.

The key point, though, is that it’s not safe to assume that everyone understands “the odds” when those probabilities are presented to them. In fact, researchers often use a (relatively short and feasible for financial advisors to use) risk literacy assessment to find out whether the individual really understands probabilistic risks, before making a decision. Which means perhaps it’s time for financial advisors to consider using such assessment tools as well. To either ensure that clients really do understand the risks they’re taking. Or at least, gain a better understanding of which clients need to have an additional explanation to really ensure they’re comfortable with the (potentially risky) path they’re choosing to take!

Meghaan Lurtz

Author: Meghaan Lurtz

Team Kitces

Risk Literacy – A New, But Old Measure

Risk literacy is a newer concept in terms of financial planning, but it has a long-standing history in behavioral sciences (i.e., behavioral economics and decision-making sciences).

The following is an example (and funny story) of risk literacy, from researcher Dr. Gerd Gigerenzer in his book Risk Savvy: How To Make Good Decisions, about a veterinary friend and a local farmer:

“A few years ago I (the vet) performed surgery to a correct a twisted stomach in a dairy cow…We know from previous studies that approximately 85 percent of cows treated by the technique recover and return to normal milk production.

Ben, the owner of the farm, asked how likely the cow was to have a problem after surgery. Trying to put it in terms that he could relate to I said, “If we did this procedure on 100 cows, I expect about 10 to 15 would not completely recover within a few weeks of survey. He paused a moment, and said, “Well, that’s good because I only have 35 cows.” (p.27) 

In essence, risk literacy is a measure of one’s ability to understand probabilities, not just in terms of general intelligence or being able to calculate them (i.e., math skills), but the ability to understand the risks those probabilities actually imply and how risky they really are (or not).

Researchers use risk literacy as a measure to try to understand how everyday individuals make decisions in the face of risk… or in essence, every decision that a person makes! Which – as the above example illustrates – can be a lot more difficult and confusing (and sometimes humorous) than we may consider.

The first “test” or measure of risk literacy was developed by Schwartz, Woloshin, Black and Welch, and was referred to as “numeracy.” The term “risk literacy” and a popular exam, the Berlin Numeracy Test (developed by researchers at the Max-Planck Institute in Berlin), has since been formalized by Cokely, Galesic, Shultz, Ghazal & Garcia-Retamero, and made very easy to use – it takes less than 2 minutes, and advisors can even try it for themselves here!

The key point about “risk literacy” is that it’s not just about math skills or general intelligence, which means it’s not safe to assume that clients who are, for example, engineers, doctors, and lawyers, will have high risk literacy. Even people who have “above average intelligence” or work in a “mathy” job may not have a good intrinsic understanding of risk probabilities (as highlighted in a recent TEDx talk on risk literacy by Dr. Gerd Gigerenzer with a few funny and shocking examples).

 

Notably, though, while researchers view risk tolerance as a trait – one that is stable and generally unchanging – risk literacy is something that can be improved. In fact, financial advisors often already help clients to become better at understanding probabilities, through the process of working with them, and educating them as financial plans are built and discussed.

In other words, the brain, with a little help in how we present and discuss probabilities, can become better at understanding, interpreting, and actually engaging with probabilistic information. Which is important, because if this is true (and it is) it’s no longer necessary to “nudge” a client towards better outcomes. Instead of the nudge, it’s possible to just teach them how to be better at thinking through the risks in the first place!

How Risk Literacy Impacts Financial Decision-Making (And Conversations)

The research on risk literacy has been applied primarily in the context of medical decision-making – for instance, how do patients make a decision about whether to engage in a risky procedure that has a 90% probability of being cured but a 10% chance of death. More recently, though, risk literacy has also started to be used to investigate financial decision-making. And what few studies have been done help us to understand not only how people understand their risk, but also how they handle or think through the risk, and even how they want risk discussed with them – which all have very important implications for the advisor-client relationship!

For instance, two relatively recent studies (one on portfolio allocations by Campara, Paraboni, da Costa, Saurin, & Lopes, and one on insurance decisions by Petrova, van der Pligt, & Garcia-Retamero) found that when an individual had higher risk literacy, they were, in turn, less risk tolerant. In essence, those individuals with greater risk literacy truly understood the risks at hand… and because they understood the risks, they made the decision to mitigate the risk as much as possible. On the other hand, it’s also possible that at least some individuals, who may be naturally inclined to over-estimate their risks (i.e., “nervous Nellie” clients), might actually become more risk tolerant once their risk literacy improves (and they understand that the risk might not actually be as much as they feared). Especially since the aforementioned studies that found risk literacy decreased risk tolerance were completed using university students, who due to limited life experiences may be more likely to under-estimate risks than over-estimate them relative to an older advisory client who has already experienced – and recovered from – multiple bear markets already. At its core, though, the key point is simply that improving risk literacy increases the likelihood that the actions a client is taking are consistent with their actual tolerance for risk in the first place – i.e., they really do understand the risks they’re taking and are comfortable with them.

Another really interesting finding coming out of the intersection of risk literacy research and financial planning covers downside risk, and how to discuss market losses with clients. A study by Newall in 2016 demonstrated that when individuals have low and even moderate levels of risk literacy (which, again, is common even with smart and affluent investors), they were more likely to not understand how it actually takes a more-than-20% gain to recover from a 20% portfolio loss. In addition, Newall also considered the role of financial literacy – not just risk literacy – in some of his experiments, and was able to show that risk literacy and financial literacy both mattered… but depending on the situation and interpretation of findings, risk literacy often actually mattered more. With the reasoning that, the more risk literate a person, the more that person also tended to have higher financial knowledge. To this end, Newall suggests a number of ways to curb misunderstanding of downside risk when working with clients:

  • If reporting a series of percent changes, it is best to also report the single aggregate change in value. In other words, humans are not great at performing the necessary multiplication of compounding gains or losses… so do the math for them.
  • Walk people through the math, and slow down their thinking, as in Newall’s study when individuals were prompted to deliberate longer on the question at hand, they did better.

Somewhat related to Newall’s work, another study by Galesic and Garcia-Retamero investigated communication style as it pertains to risk literacy. Their study showed that, at least as it pertains to finance, individuals preferred collaborative decision-making (and preferred it regardless of their risk literacy score). Collaborative decision-making is when the decision and the inputs for making the decision are discussed and considered in a back-and-forth conversation between a client and an advisor, as opposed to a more paternalistic decision-making strategy where the client would just be told what to do by the advisor.

Moreover, this was/is a striking finding because, in other arenas tested by Galesic and Garcia-Retamero, such as health, people actually prefer to just be told what to do over discussing the options based on their risk literacy (particularly if they’re already low risk literacy). Thus, it was surprising to see that with respect to portfolios or other financial decisions, people wanted the discussion, and wanted it regardless of their risk literacy score – the high and low risk literate both want to be a part of what happens to their money. Which is striking because, in financial planning, the “ideal” clients are typically referred to as delegators (who just want to delegate to someone who will do it for them), but it turns out that the truth is, at least when it comes to money, it is likely that even the delegators still really want to talk the decision through – even if, after the advisor explains it, the client decides to delegate the follow-through implementation to the advisor.

How And Why How Risk Literacy Can And Should Be Used In A Financial Planning Practice

While thorough risk tolerance questionnaires can be time-consuming (at least when done right!), adding a risk literacy assessment is easy (i.e., the Berlin Numeracy Test can take less than 2 minutes to administer). Though because each measures a different aspect of risk behavior, ideally advisors should probably have clients take a risk literacy assessment right along with their risk tolerance questionnaire.

And arguably, risk literacy assessments are especially important for advisors using an econometric risk-style assessment tool that presents them with various risky trade-offs to select. To ensure that the investor really actually understands the risky trade-offs they’re evaluating and choosing from in the first place! In fact, recent research has shown them to be less useful when it comes to predicting actual client behavior when compared to psychometric measures. And reason behind this could be related to risk literacy (or rather, a lack thereof by at least a subset of clients using the tool), that leads them to either misunderstand the question, not correctly state their own answer, or otherwise provide “conflicting” answers to multiple questions (not having the risk literacy to even understand their answers may be self-contradictory). Along with other potential behavioral biases like framing (when a person is given two perfectly equal probability scenarios, but one example uses “negative language” while the other emphasizes the positive), which can also cause people to answer what is essentially the same question in different ways!

More importantly, even if clients do not score well on their risk literacy assessment… it’s still incredibly valuable information, as now the advisor knows that their clients really may not “understand” the risk they are saying they want to take on. Or provides important context for their ability to choose a financial planning course of action based on their Monte Carlo probability-of-success results (which are another version of probabilistic risk-based decision-making, which clients may struggle with if they have low risk literacy).

Simply put, though, if an advisor wants to ensure that a client is giving accurate information as it pertains to their risk tolerance, or is making a grounded decision regarding their Monte Carlo retirement projections – make sure they actually understand the risks, to begin with, by using a risk literacy assessment as well. And recognize that a low risk literacy score still helps the advisor to know whether more education on risks and probabilities would be beneficial to the client in the first place. Being aware of a client’s low risk literacy may also help in deciding how to present information to the client. For instance, research from both Newall and other scholars in this area have found that the use of images, pictures, visual aids, and other graphical information, all help to “level” the playing field – high risk literacy and low risk literacy falls away when individuals can use an image to visualize the risk, rather than just their brains to try to conceptualize the otherwise-abstract numerical probabilities.


Maybe I am just a little bit weird, but some of the research on “nudging” clients has always rubbed me the wrong way. Nudging and all of the other stuff we know to do from the wonderful work in behavioral economics can and does work… but from my perspective, it has also always felt a little “big brother-ish” and paternalistic.

Risk literacy is an important and powerful alternative to the nudge… one that doesn’t just Jedi-mind-trick or tell clients what to do, but helps them to actually learn, grow, and develop important skills like financial self-efficacy. And that can only be done when we acknowledge and accept some responsibility for the fact that people (our clients and us) can learn and become better decision-makers. Risk literacy is a skill that can be improved upon and developed!

For advisors who want to get more familiar with the concepts and tools, visit the Risk Literacy website, and take the test for yourself and see how you do. And then consider whether/how you might start using the assessment with your clients as well.

Risk literacy has been around for a long time, and it has been found to be very helpful/useful when it comes to health decisions – and I believe this research has a direct translation to the financial planning environment. Especially for those who are using some of today’s very popular econometric-style risk tolerance assessment tools… or who are using (probability-based) Monte Carlo projections when doing retirement planning with clients.

And while there aren’t necessarily any “risk literacy educational tools” specifically made for financial advisors, remember that the research also shows that simply using pictures and graphical information (where possible) helps to develop risk literacy skills and empowers clients by increasing their financial knowledge as it relates to their financial life. You might even be surprised to find that as they, your clients, more fully understand the work you do for them, and the risks you’re helping them navigate, and then help them improve and understand the decisions they make – this could even lead to a greater appreciation of your work as their advisor!





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