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Overcoming groupthink and the relevance of risk tolerance

Groupthink is a phenomenon that can compromise investment decisions where those decisions are made jointly by a group of people.

Members of a group often suffer from a tendency to agree with each other in a group context and not openly disagree or question decisions, even where decisions are being made that the member doesn’t support. This can happen to any group of people responsible for making investments on behalf of others, such as trustees or members of an investment committee.

The end result could be that a dominant decision maker ends up driving group decisions, which could lead to compromised outcomes.

If, for example, the dominant person in the group has a higher financial risk tolerance than most other members, then that group could end up making or recommending riskier investments than most of the group members would have been comfortable with or recommended if they alone had acted.

Groupthink is therefore something that trustees of investment committee members need to be aware of and be on guard against. FinaMetrica often receives enquiries about what to do in terms of assessing the risk tolerance of trustees, individual members of an investment committee, settlors and beneficiaries. In legal terms, knowing individuals’ risk tolerances, we believe, has no role to play. However there may be a practical benefit in some circumstances.

Firstly, the point needs to be made that the service being provided by trustees to the beneficiaries is more akin to investment advising than a financial planning service. The trustees will be bound by the terms of the trust deed and trust law and so, neither the risk tolerance of the beneficiaries nor that of the trustees need to be considered in the formulation of the investment objectives or in the making of investment decisions.

However, it may still be useful for trustees to assess the risk tolerance of individual members and for this information to be shared amongst the group. Trustees who have low risk tolerance will need to be on their guard against being over-cautious or not speaking out.

For trustees with high risk tolerance, the reverse would apply. Additionally, there are groupthink studies showing that groups tend to be more risk tolerant than the individuals who comprise the groups. Groups are more likely to agree to take risks that individually they would decline. It has been suggested that individuals in groups tend to egg one another on and that the less risk tolerant are reluctant to speak up for fear of being seen as wimps.

Also, there is strong evidence of a correlation between risk tolerance and the overconfidence bias, meaning that the more risk tolerant someone is, the more they will be that their views are right. The implication here is that trustees should try very hard to avoid groupthink. Objective risk tolerance testing should be an aid in doing so.

Finally, with (small) family trusts, it may be helpful to test the risk tolerance of non-trustee adult beneficiaries and even the Settlor, if there is one, and to then discuss the results with them in the context of the risk in the investment strategy.

You can read more about groupthink and how to avoid it at Usman Hayat CFA recommends creating an environment where people can disagree and ensuring that a devil’s advocate is part of the decision-making process.

The above should not be regarded as legal advice. Advisers should obtain specific legal advice on the specific issues that might apply in each case.

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