In Standard Deviation Limitations, I noted that one potential weakness is human behavioural characteristics.
The risk tolerance of each individual is different. It is based on one’s experiences, desires, needs, objectives, and attitudes.
Understanding a person’s unique risk tolerance is critical. How investors view the risk and associated expected return of investments will guide their investment strategy. Everyone differs to some extent.
Today we will look at few questions that shape an individual’s perception of risk.
Consider how you perceive risk as we go through these questions?
Is risk the losing of invested capital?
For many, the thought of losing money is their greatest fear.
These investors typically consider the risk of losing money in absolute dollar terms as compared to the original cost of the asset. Some investors feel that money is only “lost” when the investment is actually sold. Others feel the pain even for losses that are not yet realized.
When we looked at risk, we saw that the greater the investment risk (i.e., standard deviation), the greater the volatility of the investment. That is, the greater the probability that the actual return would deviate from the expected return.
If you fear losing money, you might be more comfortable investing in extremely low risk assets. Sacrifice potentially higher returns for certainty, as well as minimizing the risk of actually incurring an absolute loss.
Is risk the unfamiliar?
Individuals often fear the unknown.
For investors, investments with which one has little or no knowledge of, or appear to be complex in nature, may be seen as riskier.
A good example is the writing of covered call options. Many investors have no experience dealing with options. The mechanics and even the terminology may be intimidating. If I suggested that they incorporate covered calls in their investment portfolio, most investors would be hesitant. Their uncertainty is internalized as increasing the investment risk.
But that is simply the perception. The reality is that covered call options can be an excellent tool within one’s portfolio. While not something I might recommend initially for investors, as investment knowledge and experience improves, one can see that certain options strategies are not risky nor overly complex to execute.
While it is fine to be cautious with unfamiliar investments, that does not necessarily mean they are more risky. Take a little time to learn about areas where you have no knowledge. You might find that the investment is not as risky, nor intimidating, as your initially thought.
Is risk being once bitten twice shy?
Individuals often view investments on which they have previously lost money as unattractive or riskier than they really are.
For example, you purchased 10 ounces of gold in 2012 at USD 1600 per ounce. The investment fell over time and you sold in 2015 for USD 1100 per ounce.
In 2017, you read that gold is recommended as a great mid to long term investment. Based on your prior experience losing money on gold, there is a strong probability you will find this new recommendation unattractive or high risk.
However, that unattractiveness or increased risk is merely a perception and not reality. Whether you gained or lost money on a specific investment in the past has no connection with how well you will do in the future.
Of course, I also meet investors who like to jump back in on investments they previously lost money on. Payback, they are due, karma, pick your reasoning.
Is risk not following the crowd?
Following the conventional wisdom and expert recommendations is usually comforting.
It is always good to find that others, especially experts, agree with your investing decisions. Or that your decisions are based on the consensus of many who may be “smarter” than you. If you lose on the investment, you can take some solace knowing that many others did so as well.
Taking contrary investment positions is more stressful to many individuals. Going against the tide may be seen as a risky proposition. After all, who are you to know more than everyone else?
For example, if the “talking heads” on the business channels are all recommending avoiding Canadian natural resource equities, it takes a bit of nerve to go out and buy shares in these companies.
Given the track record of many “experts”, I am not sure following their advice is often wise.
Investment bubbles are often the end result of following the crowd and engaging in “herd mentality”.
Is risk historically based?
Finally, investors often focus on the past when assessing risk.
Individuals consider historic returns when extrapolating into the future. While history can be a predictor of the future, it is the expected returns (and associated risk) that is more important.
Situations change, both good and bad, and that can impact the risk of an investment.
Consider a mutual fund whose mandate is shares in mining companies. Performance over the last 10 years averaged 15% and risk standard deviation was 4%. Well ahead of other funds in the same category. Based on past results you invest.
However, six months ago the fund decided to sell its investments in traditional mining companies and focus on higher risk companies in Africa and South America. Specifically, countries with less stable companies, young free-market economies, and inefficient markets. Unhappy with the shift in strategy, the successful management team quit. To save money, the fund company has the managers of their banking mutual fund take over management of the mining fund.
Although historic risk was 4%, these recent factors will significantly increase risk levels in the near future.
Data comforts investors in their decision making. And it should. But if you rely too much on the past, you might err in the future. Historic statistics are only applicable if the circumstances in which they occurred are still relevant going forward.
That is why in every mutual fund prospectus you will see “past performance is no indicator of future results.” Or similar.
How did you respond to these questions?
The answers will help you arrive at your personal risk tolerance level. This will guide you as to investments you are comfortable to invest your capital in.
Do you fear the risk of a real loss? Or do you take (hopefully, calculated and prudent) risks to attain potentially higher returns?
Do you avoid the unfamiliar? Or are you an adventurer who seeks out new investment ideas?
Does a prior loss in an asset class or investment cause you to shun them in future? Or is it a chance for revenge?
Do you get comfort relying on experts and the consensus or do you prefer going against the flow?
There are no “right” answers. How you see risk is based on your life history.
However, while risk tolerance levels are unique to each person, I would like to influence each of you to some extent.
I cannot do much about your personality, life experiences, investment objectives, personal constraints, etc. And how they all impact your risk tolerance.
However, I hope to show you that it is best to take a view of risk with as little emotional involvement as possible. That by improving your base investment knowledge and learning what questions to ask, you can become more objective in your decision making.
I fully realize that this is a challenge for almost all individual. But if you can develop a more disciplined approach to investing, you will be in better position to succeed over the long run.
