Financial advisors spend a lot of time explaining risk to the clients. But often those explanations are not understood, because clients don’t understand how to understand and respond to probabilistic risks.
Risk literacy is a serious issue for advisors, as the client’s ability to properly consent to a financial plan hinges on their ability to understand it. Sometimes, their consent might be based on a complete misunderstanding.
Probabilistic Probability is Hard to Understand
Take, for example, a weather predication that there is a 30% chance of rain tomorrow. What does this mean? Or, perhaps more importantly, what could it mean to different people?
Some people will think it means it will rain for 30% of the day — 7.2 hours of 24. Others will think it means it will rain over 30% of the forecast areas. Some may even think it means ten weather forecasters were asked their opinion and only three thought it would rain.
Many of these people will set off with umbrella, which probably won’t get used.
The 30% forecast is actually telling us that the forecaster has low confidence in their prediction — they believe it will only be right three out of ten times. So, there is a better-than-average chance that you will be dry even without an umbrella.
Another area of confusion lies around absolute and relative risk.
For example, consider a risk that increases from 1 in 7,000 to 2 in 7,000. In relative terms the risk has increased by 100%, which is frequently how the media reports such results. But in absolute terms, the risk has barely changed.
But in his TEDx talk on ‘Risk Literacy’, leading thinker Gerd Gigerenzer explains how this exact confusion around side-effects linked to the contraceptive pill led to some women ceasing to take it and experiencing unwanted pregnancies due to a near non-existent risk.
(You can watch Gerd’s talk on risk literacy here https://www.youtube.com/watch?v=g4op2WNc1e4)
Test Your Risk Literacy
The Berlin Numeracy Test is one of the world’s most efficient predictors of skilled decision making and risk literacy. It is only three questions long — but they are tough questions for many people!
This is question 1:
Out of 1,000 people in a small town, 500 are members of a choir. Out of these 500 members in a choir, 100 are men. Out of the 500 inhabitants that are not in a choir 300 are men.
What is the percentage probability that a randomly drawn man is a member of the choir?
The answer is …. at the end of this article! Meanwhile, if you’d like to complete the whole test go here: http://www.riskliteracy.org/try-it/
The results of this test have shown that many people cannot answer this type of question correctly.
Even very highly educated people such as judges, doctors and academics frequently answer incorrectly. This is an important point to recognize, as it is easy to assume that people who are highly skilled and expert in one domain are ‘smart’ across all aspects of their lives. But when it comes to financial matters, we know this is often not the case, with plenty of evidence of low financial literacy even among the highly educated.
Financial Literacy is a Real Problem
Another famous three-question quiz has been used to test financial literacy around the world — and the results are discouraging. It was developed by Annamaria Lusardi, from The George Washington University, and tested basic financial concepts.
The questions are very basic, from the viewpoint of an advisor who works with these materials daily. But many ‘non-financial’ people find them challenging. These questions have come to be known as the ‘big three’ and have been adopted by the US Federal Reserve for its research:
- Suppose you had $100 in a savings account and the interest rate was 2% per year. After 5 years, how much do you think you would have in the account if you left the money to grow?
- More than $102
- Exactly $102
- Less than $102
- Do not know
- Refuse to answer
- Imagine that the interest rate on your savings account was 1% per year and inflation was 2 % per year. After 1 year, how much would you be able to buy with the money in this account?
- More than today
- Exactly the same
- Less than today
- Do not know
- Refuse to answer
- Please tell me whether this statement is true or false. ‘Buying a single company’s stock usually provides a safer return than a stock mutual fund’.
- Do not know
- Refuse to answer
Applied around the world, this test revealed that financial illiteracy is widespread in both well-developed and rapidly changing markets.
Women are less financially literate than men, the young and the old are less financially literate than the middle-aged, and more educated people are more financially knowledgeable. Most importantly, the financially literate are more likely to plan for retirement.
See the research paper here http://media.wix.com/ugd/a738b9_9a413bc46954faf89b8f7e10d9239340.pdf
Obtaining Meaningful Consent From Clients
Clearly, advisors cannot simply assume that everyone understands probability and financial concepts that are presented to them. In turn, it cannot be assumed that all people truly know what they are agreeing to when they give consent to proceed.
That imposes both a duty and an obligation on advisors to ensure that clients have a sufficient understanding to allow them to give their informed consent to the proposal before them.
The good news is that both risk literacy and financial numeracy and literacy can be improved with education and information. Of course, that requires the advisor to have some measure to establish when education might be required. That could be a formal testing regime, using tests like those described earlier. Or it might be a less formal, personal assessment.
The starting point is to have a conversation with the client about the risks before the investment and what understanding of those risks they currently have. Indeed, this might be the most important frontline tool at the advisor’s disposal.
A study on low-numeracy decision making found a fascinating paradox between how people want to be consulted about probabilistic risk in a medical setting versus a financial setting. Even though both settings are loaded with similar probability problems, people’s need were quite different.
In a medical setting, people with low risk literacy preferred to be told what to do rather than discussing the options.
But when it came to financial matters and decisions, they wanted to talk through their alternatives — regardless of their risk literacy. Both high and low risk literacy people wanted to be a part of what was happening to their money. Read the study here https://www.ncbi.nlm.nih.gov/pubmed/21553977.
This finding might surprise advisors who believe they are commonly deal with ‘delegators’, who just want things done for them. Research shows that even these clients may want to feel involved in the decision making, through discussing the options open to them.
Telling an Understandable Story
Client understanding is an essential underpinning of informed consent. But it is a vexing issue for financial advisors.
How can an advisor know, for sure, that a client who says they understand really does understand? There are no agreed standards around confirming understanding, so each advisor has to make their own policy.
The starting point is to tell a story that is understandable to the client, which can be more complex than it initially sounds.
What is required to deliver understanding will vary from person to person, which means the story may need to be told in a variety of ways and modes. Some people will be comfortable with spreadsheets and graphs, but others will benefit from the use of Images, graphics and other visual information.
The interaction between the client and the advisor is a critical factor. It provides feedback to the advisor on what is, or is not, ‘getting through’ to the client and helps them shape their explanations.
But most importantly these conversations underpin the relationship between planner and advisor, which underpins the trust between them. This trusting relationship allows for honesty where, an advisor can probe a client’s understanding and a client can, without embarrassment, say “I don’t get it – could you explain it some more?”
Answer: What is the probability that a random man is in the town choir?
The problem is to determine the probability – in percentage terms – that a randomly drawn man is a member of the town choir.
We are told that:
- There are 1,000 people on the town
- There are 500 people in the choir
- There are 100 men in the choir
- There are 300 men in the remaining 500 non-choir-member townsfolk
The are 600 women in the town and 400 men. Only 100 men of the 400 men, or 1 in 4, are members of the choir. So, the probability of a randomly drawn man being a choir member is 25%.