“I don’t think the objective of investment should ever be to take a risk in order to get a return.”
—Benjamin Graham
Investing involves risk, plain and simple. There is no way to completely avoid investment risk unless you are satisfied with the meager return on a portfolio of CDs or Treasuries. Given the current inflationary environment, the return on these types of investments is a guarantee of purchasing power loss, a risk in itself.
There are strategies to help mitigate risk without sacrificing acceptable returns, but that is a different discussion. For now, I want to share with you my observations of how investors often jeopardize their financial futures by not understanding risk from both a market volatility and personal predisposition perspective.
As an investment manager, I am acutely aware of the various risks that threaten to derail our clients’ investment objectives, including market risks and aberrant investor behaviors, both of which affect portfolio performance.
Market risks include both systemic and idiosyncratic. Systemic (or Systematic as some prefer) affect the entire market, such as risks related to interest rates, currencies, commodities, politics, the economy and geopolitical events. Idiosyncratic risk refers to issues involving specific market sectors, industries or individual stocks.
Systemic risks are innate to the market and contribute to market volatility and uncertainty. They cannot be mitigated through asset allocation or portfolio diversification. Idiosyncratic risk, however, can be reduced through portfolio diversification and other investment strategies.
Risks arising from client behaviors include misjudging one’s true capacity for risk and destructive behavioral impulses in response to market upheaval. Fortunately, these risks can be diminished or even eliminated but usually require assistance from a professional advisor.
While it may be beneficial for clients to understand market risks, they rightfully expect me as their portfolio manager to balance these risks. It’s the reason why they hire me. On the other hand, it’s critical for investors to understand how their innate biases and instincts can undermine even the most competent investment management strategy.
Risk Misconceptions
Risk tolerance is one of the most widely analyzed and yet least understood aspects of personal investing. What investors describe as their capacity for risk often fails to match their risk tolerance reality. Most tend to overestimate the amount of risk with which they can comfortably cope. This disparity becomes painfully apparent when the market suffers a significant downturn.
When asked to define their capacity for risk, (aggressive, speculative, moderate, conservative) most will say moderate. In my experience, however, “moderate” has a vastly different meaning to different people. For some, the term represents significantly higher risk than it does to me as an advisor. To others, it implies much lower risk. It’s one of those nebulous terms used by financial advisory firms in their advertising but it has little value in trying to identify someone’s true capacity for risk.
Virtually no one describes their risk profile by saying, “I want to take it nice and slow when it comes to investment returns, avoiding as much risk as possible.” No one wants to miss out on lucrative investment opportunities because they were too timid. I’ve had clients call me during a market upsurge, a time when they should be rejoicing, and ask why we still have a small percentage of their portfolio sitting in cash. I understand but do not agree with investors who desire to secure every drop of gain during a market expansion. I ask them if they are willing to sacrifice portfolio stability in exchange for a small additional gain. Their generally respond in the negative. When they answer “yes,” I try to convince them otherwise. When I fail, I often have to suggest they find a different advisor. I never want to be party to someone absorbing unacceptable losses as a result of taking unnecessary risks.
Another factor that contributes to investors overstating their capacity for risk is the mistaken notion that taking greater investment risk will automatically result in higher returns. That’s not necessarily the case, however.
A recent article in the Economic Times reports that the theory, taught widely in business schools, holds that stocks with higher volatility need to deliver higher returns to investors to compensate for the higher risk taken. While some asset classes tend to be more volatile than others—such as equities versus debt—many studies indicate that stocks with higher volatility do not exhibit higher returns than stocks with lower volatility. This is perhaps one of the biggest anomalies in modern finance.
When I ask a couple about the amount of risk they can sustain, they sometimes “misunderstand the question” as my grandfather used to say. They think I’ve asked them if they want to grow their money fast or grow their money slow. What I’m actually asking is, “What happens when the market is in freefall and your portfolio is taking a major hit? Do you have the mettle to ride it out?”
Sometimes, it takes an event like this to clarify someone’s true capacity for risk. Those who overrate their ability to deal with severe or prolonged market volatility have a tendency to disengage from the market at the worst possible time.
“You make most of your money in a bear market, you just don’t realize it at the time.”
—Shelby Cullom Davis
Risk Assessment
I generally recommend new clients allow me to measure their capacity for risk using a risk assessment tool, software that simulates various market scenarios and, based on the investor’s reactions, produces a risk estimation on a scale of 1 to 99. A score in the single digits indicates someone who may be best off psychologically by burying their money in the back yard. A score in the 90s suggests an investor willing to ignore virtually all uncertainty and “invest full speed ahead.”
While the software reveals a broad array of scores, the majority of people analyzed tend to fall somewhere between 40 and 80 on the spectrum. Virtually all of these people describe their risk tolerance as moderate. In my experience, a score of 40 indicates a conservative investor whereas an 80 score investor is comparatively aggressive. The fact that such a wide band of investors ranging from 40 to 80 all think of themselves as being comfortable with the same level of risk is an example of how difficult it can be for investors to acquire a clear picture of their actual capacity for risk.
I’ve had numerous instances where the risk survey indicates a new client has a risk score of 50. When I review their existing portfolio, however, I find they are heavily invested in a mutual fund or other products with a risk factor of 80 or 90. This is another reason for utilizing the risk assessment tool: it lets me help clients understand their investment strategies to more closely align their holdings with their actual risk tolerance.
The most schizophrenic portfolios I’ve seen over the past quarter century belong to do-it-yourself (DIY) investors. I’ve encountered individuals overweighted with penny stocks and other high-risk investments who believed they had achieved portfolio “balance” by purchasing a few CDs—their idea of diversification.
Uncompromising Conversations
While having a rigorous conversation to determine a client’s true capacity for risk can be an eye-opening experience, it’s far more beneficial to have that conversation in advance of an outlier market event than after the fact. I prefer to have a client go elsewhere rather than my having to go against what I know to be valid, in order to make the client feel comfortable and engage me. They may not always take to heart what I am trying to get them to understand but most clients recognize the reason for the conversation and are agreeable.
On occasion, I am unable to convince a client to alter their investment mandates to accurately reflect their true risk tolerance when necessary. In one instance, an investor who is no longer a client was calling me daily during the financial crisis of 2008. The conversation would invariably conclude with me advising him to stay the course, ride it out and have patience that the market would recover, as it historically always has. Our second-last call was a particularly lengthy and trying one for me as I was trying to keep the individual from absorbing an unnecessary loss by selling out all his equities and moving to cash. He finally acquiesced.
The next day, the market suffered another precipitous loss and sure enough, he was back on the phone with me, this time delivering a profanity-laced tirade that would have made a sailor blush. I listened silently until I was unwilling to endure any further verbal abuse. Letting him know I continued to believe he was making a disastrous mistake, I agreed to sell him out.
Two days later, the market bottomed out and began a rapid recovery. Not only would my angry ex-client have avoided the loss he sustained by prematurely selling out, he could have quickly recouped his initial loss and participated in an historic market boom. His inability to act rationally and manage his emotions cost him a small fortune.
Incidentally, I ran into him a couple years ago and he apologized profusely. “I know this doesn’t make up for my behavior, but I know now that you were trying to keep me from making a huge mistake. I’m sorry. I’m in a worse situation than I would have been had I listened to you.” I accepted his apology but I didn’t invite him to return as a client.
In retrospect, I often wondered if I had been just a tad more tolerant and patient with him, I might have been able to convince him to hold it together for a couple more days when the market began its rebound. Of course, no one knows exactly when a market downslide will end and reverse itself. What we do know is that it always happens; sometimes sooner, sometimes later. I do feel bad, however, that I wasn’t a good enough negotiator to convince him to stay the course. On the other hand, I think my client would rather I be a good advisor and investment manager than a good salesman.
“Large losses are forever—in investing, teenage driving and fidelity. If you avoid large losses with a strong defense, the winnings will have every opportunity to take care of themselves. And large losses are almost always caused by trying to get too much by taking too much risk.”
—Charles Ellis