08 May 2015 Risk: The Most Important and Most Misunderstood Element of Investing

The most important concept in investing and yet, the most misunderstood, is that of risk. The mere mention of the word causes a visceral reaction in our bodies that most find unpleasant while a few find it strangely stimulating. A proper understanding of investment risk and the levels we can bear over relatively long periods of uncertainty has a fundamental and profound impact both on our current and our future lifestyle. Even if every detail of one’s investing process is optimally designed, he will fail or fall far short of his potential if he does not grasp a firm understanding of his ability to endure the risk his portfolio will deliver through the uncertainty that surely lies ahead.

Financial or investment risk is broadly defined as the chance that an investment’s actual return will be different than expected, including the possibility of losing some or all of your money. The financial services industry reasures risk by calculating the standard deviation of the historical returns or average returns of a specific investment. A high standard deviation indicates a high degree of risk.

The industry (and its regulators) pay keen attention to risk as they spend  significant amounts of time and effort to measure the precise point at which their clients will become uncomfortable with it. Once evaluated, the client is categorized as “suitable” for certain products or investment options that fall within (or just below) the level of risk they are deemed capable of accepting.

But if the industry devotes so much expertise, time, and effort to measuring their clients’ ability to tolerate risk then why do so many of their clients have such poor investment results? There are countless studies like those from Dalbar indicating the wide divergences of investor performance from broad market performance. Dalbar’s latest shows that while the S&P 500 returned 11.06% over 30 years ended in 2014, the average equity fund investor received only 3.79%? The results are surprisingly similar every year.

The difference is called the ‘behavior gap,’ or stated alternatively, the result of a poor understanding of how handle risk when it presents itself. Investors abandon their plans and investment policies when markets decline or rise faster than their emotions can handle. Dalbar has recently released a study showing when the biggest gaps or emotional mistakes have occurred.

To properly understand risk and our ability to accept it we must look beyond the scope of broadly used industry risk assessment tools. In a fascinating NY times article entitled “The Biology of Risk,” John Coates notes that “We do not process information as a computer does, dispassionately; we react to it physically. For humans, there is no pure thought of the kind glorified by Plato, Descartes and classical economics.” The traditional risk questionnaire falls short because it can scarcely evoke the human or biological reactions we will have when we actually encounter the risk, making it almost impossible to predict or measure accurately. And as we will learn from Coates’ article, the measure of risk is not static, but changes with uncertainty and the duration of that uncertainty.

“Most models in economics and finance assume that risk preferences are a stable trait, much like your height. But this assumption, as our studies suggest, is misleading. Humans are designed with shifting risk preferences. They are an integral part of our response to stress, or challenge.

When opportunities abound, a potent cocktail of dopamine — a neurotransmitter operating along the pleasure pathways of the brain — and testosterone encourages us to expand our risk taking, a physical transformation I refer to as “the hour between dog and wolf.” One such opportunity is a brief spike in market volatility, for this presents a chance to make money. But if volatility rises for a long period, the prolonged uncertainty leads us to subconsciously conclude that we no longer understand what is happening and then cortisol scales back our risk taking. In this way our risk taking calibrates to the amount of uncertainty and threat in the environment.

Under conditions of extreme volatility, such as a crisis, traders, investors and indeed whole companies can freeze up in risk aversion, and this helps push a bear market into a crash. Unfortunately, this risk aversion occurs at just the wrong time, for these crises are precisely when markets offer the most attractive opportunities, and when the economy most needs people to take risks. The real challenge for Wall Street, I now believe, is not so much fear and greed as it is these silent and large shifts in risk appetite.

I consult regularly with risk managers who must grapple with unstable risk taking throughout their organizations. Most of them are not aware that the source of the problem lurks deep in our bodies. Their attempts to manage risk are therefore comparable to firefighters’ spraying water at the tips of flames.”

The huge takeaway here is that our preference and tolerance for risk vary with time and economic/market/life circumstances. Just like planning, measuring risk tolerance is not a one-and-done proposition. If important changes have occurred, subtle or dramatic, they must be captured and discussed in the planning process to better inform decisions and ideally to prevent the kinds of emotional reactions that will surely jeopardize or ruin the life plan.

The best tool we have found to date to measure our clients’ current appetite for risk is Riskalyze. It, better than any we have seen, evokes the emotions interactively from the perspective of our client’s actual assets, demonstrates in dollars what losses and returns they can expect in possible future market swings. It realistically puts the client into the statistically best and worst situations they may encounter so they can determine how they will emotionally react, better informing their risk preference and tolerance.

Given that markets have been on a relatively stable upward trajectory for the past six years, perhaps today is a great time to reassess your risk tolerance. You can access our Riskalyze tool by clicking the button below–let us know what you think!