Most have heard the expression, “No risk, no reward,” or some variant thereof applied to investment philosophies. Within that statement is a fundamental logic that dictates how investors and asset managers should be building suitable portfolios, and it goes something like this: “A rational individual will expect greater performance potential from an investment with greater perceived risk.” The degree to which one is willing to accept higher risk is commonly referred to as “risk tolerance.” Being aware of this attribute is an essential component of the asset selection process, and it is important for a couple of reasons:
One, it affords some degree of psychological preparation for the range of returns (both positive and negative) which can be anticipated over time. Secondly, it provides parameters investment managers can use to select an asset mix suitable for the client’s feelings about potential gains versus potential losses. This article will address both the advisor and client perspective of risk, and why I believe it may need a candid reevaluation. But first, let’s establish our definition of “risk.”
For most people, risk typically translates to, “What do I stand to lose?” This sentiment is not surprising or unnatural, considering that is how we frame the word when applied to most areas of life. When it comes to investing, however, risk is evaluated from a broader, more dynamic perspective. Since a loss only happens when an individual closes a position, what we are really dealing with is an attempt to define the conditions that may emotionally compel an investor to take such actions, thereby realizing an actual loss of value. In short, the most significant question both investors and advisors must ask is, “How much downside volatility can be tolerated before the rational mind submits to irrational fear and the (often destructive) decisions that follow?” In attempting to answer this, we find the basis of our struggles in understanding risk.
I entered this industry in late 2000, right in the middle of the worst market crash since the Great Depression. After enduring an even more severe crash in 2008, I began to rethink the concept of risk and how dangerously skewed our perspectives of it becomes as a what I call “risk relativity” begins to cloud our thinking.
As a disclaimer, I have conducted no clinical studies on this subject, thus have no statistical data to support my premise. But I do have nearly two decades of experience in dealing with people, their money, and the markets. If nothing else, perhaps what follows will help you to rethink your own understanding of risk, and may even save you from yourself (or, more specifically, your brain) the next time you’re staring down one of those pivotal moments that make or break the average investor. Since “risk relativity” is also a term of my own creation, I’ll describe what it means to me:
From my observations, a person’s ability to psychologically cope with a certain degree of downside performance is not static; it’s relative. In other words, contrary to popular understanding, a person is not naturally or staunchly a conservative or aggressive investor, but, rather, a certain degree of either; and the degree of that degree can (and will) be influenced by something psychologists call a “recency bias.”
The Skeptics Dictionary defines this phenomenon as, “The tendency to think that trends and patterns we observe in the recent past will continue in the future.” This leads many investors, regardless of true aversion to loss, to exhibit a greater willingness to accept higher risk exposure during a sustained period of positive market performance. Of course, the opposite scenario would also produce similar effects as people begin to feel more conservative after a deep market correction. The obvious problem with this “sentiment-drift” is that it often results in portfolio reallocations at the worst possible moments as investors repeatedly by high and sell low; a scenario triggered by the natural responses to fear and greed shared by all humans.
So, let’s put my hypothesis to the test: Here we are at the end of the third-longest bull market in history, with equity prices at all-time highs, and an evolving situation where it seems no amount of bad news can slow things down. If you are like many investors I speak with, you may be feeling like you want to get in on more of the action. If so, you must understand that the only way to get a bigger slice of that growing pie is to increase your market exposure and accept the increased volatility that comes with along with it. In other words, if you want more upside potential, you must first determine if you can also handle the potential for much deeper declines. If your answer is, “I’m not sure,” that’s a good thing—at least you’re thinking about the possible scenarios ahead. If your answer is, “Absolutely!” let’s step things up a bit …
What if I told you the odds are exceptionally high (and rising) that we could experience another 2008-like event in the next 12 months? Do you want to get in on that action too? Think about what it will feel like to open that statement in June of 2018 and realize your account worth $500,000 today has fallen to $200,000. Does that change your perspective? It should.
This matter of perspective, and the ability to envision and anticipate all future scenarios (not just the good ones), creates the challenges both advisors and their clients must face if we adhere to the traditionally rigid parameters of defining risk tolerance: Nobody would stay in an aggressive position if they felt there was a legitimate risk of that kind of loss in the near future. Yet, this is the established protocol followed by millions of investors across the country. And, just like in 2000 and 2008, many will soon become intimately familiar with the problem of risk relativity.
Now, before the storm rolls in, is the time to perform a serious gut-check to determine your true attitudes about risk. Don’t think about how much money you want to make- everyone wants to make more when times are good. Instead, think about how much you can stand to lose. Pondering such things after it’s already gone isn’t going to make it come back, so try to stay ahead of that situation.
Above all else, remember, the market is cyclical. Unless the global financial system is completely decimated, there will again come a time when visions of growing wealth and capital appreciation can, and should, be the primary drivers of your investment decisions. The question you must ask yourself (and your advisor) is, “Is this the right time for that kind of thinking?”