Risk, Emotion, and Investing
Introduction
Risk tolerance is an important building block in portfolio construction. A lot of attention gets paid to diversification, fees, and investment quality. While those are important, what I most often see disrupting a portfolio’s success is one’s inability to handle the downside of the market. The goal is to stick with a strategy, and that requires confidence. Understanding risk tolerance is the key to this confidence.
But the traditional way we understand and communicate risk tolerance is lacking. The result is unhappy investors, ones that feel cheated or wronged, and the ensuing reputational damage to the industry is stark. Despite this, many investors and advisors alike pay too little attention to the amount of volatility an investor can handle.
In this article we will go over the shortfalls of our current understanding of risk and some exercises to help you account for the risk you are taking in your decision-making.
The Problem with Traditional Risk Profiling
1. People Are Bad at Predicting Their Own Risk Tolerance
You’ve encountered risk questionnaires before; they ask questions like—
- "How would you feel if your portfolio dropped by 20%?"
- "Would you prefer steady returns or higher risk with a chance for bigger gains?"
The issue is that the people who need risk tolerance questionnaires the most are the people least equipped to answer these questions. To understand your risk tolerance, you have to understand the risks you are taking. Retail investors, especially those who have not experienced market losses in the past, are not well equipped to know what they would do when a risk they improperly understood has consequences they didn’t expect.
2. Risk Tolerance Changes Over Time
One of the biggest challenges with measuring risk is the assumption that tolerance is a static, logical thing. It leads us to attempt to measure it and ask questions that treat it like a ratio. Instead of the questions above, a better question might be—“How would you feel if you lost your job, you were feeling insecure about your future and your relationship with you spouse, and the recession that cost you your job is also losing all your retirement money, and THEN I tell you not to worry about it. How would you feel then?”
People take risks when times are good, and feel risk when times are bad. Emphasis on the feel. In the same way that we are more likely to buy food when we shop hungry, and we are more likely to take risks when things look abundant. Never shop for food hungry? A new motto should be never invest excited.
3. Traditional Risk Profiling Ignores the Pitfalls of Overconfidence
One of the most common answers to “what would you do if…” is “I came to your firm so I wouldn’t lose 20%.” This highlights one fatal flaw for many investors: believing that skill makes gains in the market. Investors can believe they, or their advisor, are skilled enough to “see what’s coming” and avoid risks that are inherent to investing. If you invest, you will live through a recession, it will not feel good, and your portfolio will lose value. Any attempts to avoid this reality can contribute to long-term failure.
The industry uses this misconception of skill to sell. There are still a lot of salesmen out there trying to sell you the next big thing. The very pitch that brings people to the investment might be setting them up for failure, and a risk tolerance quiz can’t measure that. Before you sign up for an investment make sure you are an investor, not a lead. Leads make money for the company, investors make money for themselves.
A New Paradigm for Risk
Finding new ways to understand risk tolerance means challenging preconceived notions of investing. The result, in my experience, can be a bit jarring; but not as jarring as the unexpected consequences of risk. Whether you are an advisor working with clients, or an investor working with their own portfolio, try these thought experiments to better frame risk.
- What if your investment were guaranteed to lose a lot at some point?
I once spoke to an employee of a large tech company with millions in stock options, and he told me he would know before ANYONE if there was trouble (since he worked there), and then he’d sell before anyone else. Not too long after, the company was embroiled in a scandal and the stock lost a large portion of its value. His net worth did, too. He had successfully denied the risk he was taking and the possibility for loss.
It's easy to avoid the realities of risk, especially when we are confident in ourselves. Reframing that confidence means guaranteeing yourself that you will lose and trying to get into that headspace. Regardless of the investment, there is a near certainty that it will lose at some point. Does that damper your excitement for the investment? Because if it does, or if you honestly can’t imagine the investment losing, you might be entering into an investment with rose colored glasses.
- Avoid emotionally driven investing decisions by writing it down.
One way to test the validity of your strategy is by writing down the reasons you are going into the investment to begin with. Review these reasons: why do you believe this investment will help you meet your goals? What are characteristics of the investment you like and don’t like? What could change that would make you rethink your investment? You should have answers to these questions beyond “it will go up”.
Writing these reasons down provides you with something to review when things aren’t going well. Are the reasons you originally invested still valid? If they are, you have no reason to sell at a loss. If the reasons are no longer valid, reconsidering the investment becomes an option. This allows you to cut through the emotion and make a more measured decision.
- When it’s good, you’re good. But when it’s bad, what are you?
Understanding how you react to pressure is key to understanding how you might react to risk. In general, when things get stressful, I’ve found people move towards Safety, Action, or Information. When you are presented with stressful times, do you:
a) only feel good if you are doing something about it, even if the thing your doing might not be helpful? You might respond to stress with action.
b) seek comforting things that help you think of something else because you can’t make good decisions while stressed out? You may prioritize safety in stressful times.
c) believe that by gaining more information you will likely understand how to proceed? Information might help you feel in control when the going gets rough.
None of these answers are right or superior to the others. You may fit into one category, all of them, or even some fourth category I haven’t encountered. We all have our coping mechanisms for stress and understanding what they are allows you to consider the needs of your future, more stressed-out self.
- Become an emotional accountant.
In the same vein of writing it down, understanding yourself and how your investments are effecting your mood is important. Both can be achieved by making an account of your moods, thoughts, and experiences through the market cycle. Some achieve this with a journal, others with ongoing investment plans. It doesn’t need to be extensive, just enough to understand your tendencies and how your emotions drive them.
Investing has long been seen as an act of rationality and measuring risk tolerance has taken this approach to the detriment of the people who rely on it. Investing is a financial journey, but it is also an emotional one with themes of personal validation and insecurity. Taking risks is inevitable in investing, and you will undoubtedly feel certain ways about the risks you take that go against you. Instead of avoiding and these truths, getting to know this aspect of your tolerance can make you a better investor.
