Wealth, risk – it’s all about perception

This article appears in the February 2022 issue of Advisor’s Edge magazine. Subscribe to the print edition, read the digital edition or read the articles online.

Clients don’t only care about absolute outcomes — they care about their position relative to others. That’s why clients tell you about the friend whose portfolio returned 30%, and why as reported here a lottery winner’s neighbours will spend to the point of bankruptcy to keep up with their peer’s sudden wealth.

New research shows that how clients perceive their wealth relative to others also affects their risk tolerance.

A 2021 paper (see below) discusses our locus of control, or the extent to which we perceive life’s outcomes as within our control or as the result of luck or fate. Those with an external locus of control (the fatalists) are more likely to gamble than to invest in education, for example.

The authors asked research subjects for their net wealth. Half saw response categories with wide intervals, with the lowest category ranging up to €275,000; the other half saw categories with small intervals starting from €2,500, with the highest category beginning at €112,000.

Based on German demographics, virtually everyone in Group 1 would fall in the lowest category, while most respondents in Group 2 would fall in the middle and top categories. That means a respondent in the 60th percentile of the German population would have been in the lowest category in Group 1 and therefore making upward comparisons; in Group 2, that person would have been in the highest category.

The authors then asked respondents to guess the pre-tax income for the wealthiest 10%. Those in Group 1, who were induced to perceive their relative wealth as low, believed the top bracket’s income was 21% higher than those in Group 2.

With their perception of relative wealth measured, respondents were asked to choose from a set of six gambles to test their risk preferences. The authors found those induced to perceive their relative wealth as low were more likely to take risks. The finding aligns with research on status concerns that has found gambles are more attractive for the less wealthy who see taking more risk as the best option to improve their lot.

Locus of control also is important to how risk interacts with perceptions of wealth. Respondents who believed they could control their lives weren’t affected by the skewed perception of relative wealth. The fatalists, on the other hand, increased their risk tolerance substantially.

The study shows how important perception is to economic decision-making. For advisors, that would suggest it’s not enough to show clients how they’re measuring up to their own retirement goals. To truly understand risk tolerance, it may be necessary to understand how a client perceives their wealth relative to others, and to what extent they believe they can control it.

“Perceived Relative Wealth and Risk Taking” by Dietmar Fehr from Heidelberg University and Yannick Reichlin from the European University Institute, published in the CESifo Working Papers series, August 2021

Mark Burgess

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Mark was the managing editor of Advisor.ca from 2017 to 2024.