What do we think about when we think about investment risk?
What to eat for dinner tonight, maybe. Or whether to book the dog for a grooming this weekend.
Our minds wander when confronting this most basic aspect of portfolio building and it's only partly our fault. The financial industry's preferred tools to help people assess their risk tolerance often elicit superficial answers, not a careful analysis of the most suitable blend of risk and return for one's needs and temperament.
For example, investors often gravitate toward portfolios perceived as medium risk, no matter the details on how they're constructed. "It's like people who always order a medium coffee," said Kelly Peters, managing partner and principal at BEworks, a research firm specializing in behavioural economics. "Do they ever ask how many ounces are in the coffee, and calibrate accordingly?"
As part of an initiative to build a better risk tool, BEworks recently conducted a study that raises questions about how people assess their ability to tolerate losses. It's clear that both investors and the financial industry need to do a better job on this.
Now is an ideal time for people to pay more attention to investment risk. Since the crash of 2008-09, stock markets have surged enough to raise questions about when the next market downturn will happen. As of Nov. 30, the S&P 500 and S&P/TSX stock indexes had five-year annualized gains of 17.6 and 10.9 per cent, respectively. Both of these gains are above the long-term averages.
A resurgence in global economic growth could drive another year of solid gains in stocks, but investors must evaluate how their portfolios are positioned to deal with a potential decline.
In other words, they need to think about risk.
Risk assessment tools are commonly used by investment advice firms to comply with the know-your-client (KYC) rule enforced by securities regulators. Advice must flow from knowledge of the client's personal situation, including his or her tolerance for risk.
The tool used to assess risk is typically a questionnaire that asks people to look at a few investment portfolios, each with different potential gains and losses over a one-year period, and then pick the one they would be most comfortable with. The portfolio choices typically include high and low risk options, and a couple of choices in between.
BEworks uncovered two flaws in this process.
First, roughly one-third of people tend to pick middling risk profiles, regardless of what the hypothetical gains and losses are for those portfolios.
Second, people react differently when the exact same portfolio returns are expressed in dollar terms, market value and percentage gains and losses.
An investor thinking rationally would pick the same portfolio option on a risk questionnaire, regardless of how of how it was presented.
But BEworks found that people are very much influenced by what they see on the page or computer screen.
The firm's research was carried out through an online questionnaire completed by 1,759 people, many of whom responded to invitations on my Facebook personal finance community (facebook.com/robcarrickfinance) and my daily blog, Carrick on Money (tgam.ca/Dxew).
They were asked to comment on an actual risk assessment questionnaire used by a major Canadian financial institution. It asks clients to pick the most comfortable choice from among four $10,000 portfolios, each with progressively bigger potential gains and losses over a one-year period. The underlying idea here is that to get bigger returns, you have to accept the possibility of larger losses.
To find out how investors chose the best fit for themselves, BEworks broke the participants in its study into groups and showed each a different set of four portfolios. In all cases, the most popular choice was the No. 3 portfolio in the group of four – something approaching that medium coffee, in other words.
Some survey participants saw a third portfolio with a hypothetical $12,400 on the upside over one year and $8,400 on the downside. Others saw a third portfolio that ended up at $11,800 or $8,900. Still others saw a range of $13,000 and $7,900.
Despite the differing risk levels in these portfolios, each attracted the same 33 per cent or so of respondents.
Two interesting side notes: There wasn't a notable difference between the risk preferences expressed by men and women, and study participants who rate their investing expertise as strong chose portfolios no differently than those who described their knowledge level as fair.
BEworks also examined how people are influenced by the way in which various portfolio risk levels are described to them. Study participants were again asked to look at some hypothetical $10,000 portfolios and pick the one that they felt most comfortable with. But this time, BEworks described the portfolio performance in three different ways – as total market value, gains or losses in dollar terms and percentage returns.
Groups of participants were shown different pairings of these descriptions – for example, some saw market value compared against dollar gains and losses, and others saw market value and percentage returns. Rationally speaking, this shouldn't have mattered.
A $10,000 portfolio with the potential to gain $1,200 and lose $400 over a year is the same as one that might gain 12 per cent and lose 4 per cent and the same again as one that might grow to $11,200 or decline to $9,600. And yet, being shown gains and losses in dollar terms and percentage returns seemed to put investors in a more conservative mood than overall portfolio market value.
The real-world risk assessment tool that BEworks used is pretty standard. Chances are good you've seen something similar if you've bought mutual funds through an adviser or someone in a bank branch, or if you've used a portfolio planning tool offered by an online brokerage. Until BEworks figures out a better way to gauge risk tolerance, these tools are the best we have.
Here are three steps to get the most out of them:
- Rather than picking a mix of risk and return that seems good in the moment, have an idea of what rate of return you need to meet your financial goals; 5 to 6 per cent after fees is realistic for long-term results from a balanced portfolio.
- Think back to your actual losses in previous years and how much anxiety they caused you.
- Understand that most investors, even if they don’t realize it, will be happier and less likely to sell at the wrong time if they have lower rather than higher risk portfolios.
Above all, force your mind to engage with the rather abstract concept of investment risk. Don't wait until the next stock market crash to get your head in the game.
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BEworks examined how people are influenced by the way in which various portfolio risk levels are described to them. Study participants were asked to look at some hypothetical $10,000 portfolios and pick the one that they felt most comfortable with. BEworks described the portfolio performance in three different ways – as total market value, gains or losses in dollar terms and percentage returns.