The Risk Riddle of Investing

This is a guest commentary by Paul Keck.

The Riddle: Most investors are risk averse, so how do so many of us end up with asset allocations so high in stock that we cannot hold through market downturns? Where does this disconnect come from?

Let’s begin by looking at the definition of risk aversion. Behavioral finance defines it in this way: investors are naturally averse to risk so they demand compensation for taking it. The risk we trade for is the risk of losing money on our investment. That’s clear enough, but we don’t seem to understand when risk is lurking behind our investment decisions.

While most investors are risk averse to some degree, at one end of the spectrum we find some who are extremely risk averse and don’t want to hold equities at all, and at the other end we find risk takers–those who enjoy taking risk. These are inherent traits that we bring to the investing arena with us. So, it should be clear that individual investors do not see risk in the same way. Risk perception and aversion vary from person to person.

We often hear that we should choose an asset allocation (AA) that is consistent with our risk tolerance, but clearly something is wrong because the record shows that many investors bail out when the going gets tough. That should not happen if the AA is really in line with one’s risk tolerance. This fact should raise a red flag–our perception of our own risk tolerance is not accurate and not a reliable indicator of how much risk we really can handle. To further complicate this, our perception, and thus our risk tolerance, is variable with time, market conditions, and the perceptions of of the crowd. Risk aversion is unstable. And to make it worse, we tend to be the most risk tolerant at the worst time–when greed and euphoria are high. And typically, this is when new investors choose to enter the market–and they bring expectations of high returns. What about the accompanying risk? It’s not on the radar at all. So, while investors can easily understand what risk aversion is, we clearly do not understand when risk is present and how our personal asset allocation decision controls it in times of stress.

There are a number of reasons why perceived risk tolerance and real risk tolerance do not align. One fundamental problem is our assessment of risk tolerance is based on some built-in psychological attitudes that may lead us to incorrect conclusions. A second problem is loss aversion, which is another behavioral concept. Loss aversion addresses the fact that investors feel much more pain from a loss than they feel pleasure from an equal gain, but they don’t appreciate this until the loss is occurring. The emotions generated by loss aversion can be in conflict with those generated by risk aversion, which adds to emotional confusion and doubt. And if this isn’t enough, when markets become volatile and unsettled as in the past few years, uncertainty enters the picture.

Uncertainty is the risk that is left when all known risks have been counted. Investors can get an idea of the known risk involved by investing in stocks from the calculated expected return on stocks, so we have something to work with in deciding whether the expected return is worth the risk we must take. But the dark shadow of uncertainty takes away the ruler, so uncertainty is the most disturbing risk of all.

After a market crash, we investors are very aware of risk and we are very averse to it, and some never invest in the market again. We are very much risk averse when the market has tanked, and not risk averse–or more accurately–we don’t sense any risk when the market is high. Again, human nature provides faulty signals.

So, how should investors best approach asset allocation considering we normally create our allocations in good market conditions?

First, we need to be aware that our chosen allocation, although usually created without market stress, is still created under a mixed and confusing load of individual preconceptions and biases that aren’t even constant. That means it’s not only likely that the AA is wrong, but it’s likely to be wrong on the high side. So, we should bring the stock allocation down a notch from what we perceive to be correct. It is far better to go into a bear market with an untested AA that is on the low side rather than on the high side.

It is quite common to hear new investors say “I’m young and have many years to invest, so I can withstand bear markets losses and hold an AA of 100% equities.” This is naive thinking. The historical returns of a an 80% stock-20% bond /cash portfolio is only slightly lower than a 100% stock portfolio, but the reduction in downside risk is meaningful. That means investors take on disproportionately higher risk for the small increase in potential return generated by an all-stock portfolio. Therefore, an all stock portfolio is not a rational choice.

As you now realize, our attitudes about risk vary greatly and they are likely to be distorted. To combat this distortion, we need to be tuned into the fact that if we believe we can handle a high stock allocation without concern it does not mean we can handle it under the stress of significant asset losses.

Common sense, reasonable risk, and reasonable expectations are the road to success. Our goal is not to find the maximum expected return or maximum stock allocation we can tolerate; it is to find the allocation that matches our needs and financial ability without exceeding the limit we can handle without folding. This means we need to be in our comfort zone not only in good times, but also in bad times when we will surely be tested.

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A retired chemical engineer, Keck became passionate about investing 11 years ago. Since then he’s made a study of many aspects of investing, including the field of Behavioral Finance and the light it sheds on how we behave with our money. An active contributor to the Bogleheads and Morningstar online investor discussions, Keck has also written an online primer to investing, Road Map for Investing Success. He says the single best investment decision he ever made was in his personal financial education, and attributes this to the discovery of the Morningstar ‘Bogleheads Unite’ forum, and most especially to Taylor Larimore, one of the original founders of the forum, and co-author of  The Bogleheads’ Guide to Investing.  He lives in California and when he isn’t thinking about smarter ways to invest, he likes to play golf and bike ride on a regular basis.

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Portfolioist welcomes your comments, suggestions for articles, and potential guest blogs. Contact byrnesn@folioinvesting.com.


3 thoughts on “The Risk Riddle of Investing

  1. Steve Thorpe

    Very well written – thank you Paul! I especially enjoyed these words: “we should bring the stock allocation down a notch from what we perceive to be correct. It is far better to go into a bear market with an untested AA that is on the low side rather than on the high side.”

  2. Neil Kennedy

    Here is an unusual risk questionnaire from Rutgers University that drills down beyond the basic questions. This quiz was developed by two university personal finance professors, Dr. Ruth Lytton at Virginia Tech and Dr. John Grable at Kansas State University. By taking this quiz you will be contributing to a study on measuring financial risk tolerance.
    http://njaes.rutgers.edu/money/riskquiz/

  3. Pingback: Tweets that mention The Risk Riddle of Investing « Portfolioist.com -- Topsy.com

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