Understanding Behavioral Risk Index

Just like some people are at higher risk of using drugs (harming their health), some investors are at higher risk of doing a different kind of stupid things (harming their wealth).

The Behavioral Risk Index is a single number from 1 to 10 that indicates the investor’s tendency for irrational investment behavior. The higher the number, the more likely they will panic during market turmoil and make poor investment decisions.

If you have heard about the concept of Risk Composure from Michael Kitces (the famous blogger) and Daniel Crosby (Orion), it is essential the same concept, or rather, the opposite. An investor with high risk composure has low behavioral risk. Had we heard about Risk Composure earlier, we could have borrowed the term.

The Behavioral Risk Index is color-coded to give you more intuition. The lower numbers (green) indicate that the clients are generally on top of their emotions during market turmoil, while clients with higher behavioral risk will need your help to prevent harmful actions.

Volatility and drawdown measure portfolio risk; the Behavioral Risk Index is their counterpart in measuring an investor’s risk of harmful behavior. So, they measure different things.

Portfolio decisions are primarily driven by the client’s risk tolerance and time horizon. Once the portfolio decisions are made, clients should stay on course, but many have trouble with it. The Behavioral Risk Index helps you better guide those clients, to put a seat belt around them to keep them in their seats.

So, the answer is: no, Behavioral Risk Index doesn’t impact the client’s asset allocation.

You may argue that if two clients have the same risk tolerance and time horizon, the one with lower behavioral risk can have a more aggressive portfolio. This makes sense too–because they can handle market risk better, why not pushing them a bit? This is the approach that Orion takes, to add up risk tolerance and risk composure when making portfolio decisions. If you want to push your client to their limits, this may make sense.

The following behavioral factors contribute to the Behavioral Risk Index.

• Investor type
• Risk Inconsistency
• Financial IQ
• Loss aversion, a behavioral bias
• Overconfidence, a behavioral bias
• Herding, a behavioral bias
• Logical/emotional, part of Describe Yourself
• Spending habit, part of Describe Yourself
• Thinker/follower, part of Describe Yourself

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