A while back I was at the park with my daughter along with a number of other parents and kids. Many adults were telling their kids to get away from certain areas or to stop climbing on playground equipment reminding them that their friend got a black eye when he fell or that they would hurt themselves. I even found myself battling the same instincts when my daughter wanted to play in the creek though my reason was simply because the water was dirty. I started thinking about kids and parents at the park and what that has to do with investing. I realized that whether I’m playing with my daughter or managing client portfolios, I think about risk.
What is risk aversion?
We are afraid of the unknown for really good biological reasons. Whether our ancestors were concerned with saber tooth tigers or unsure about which plants in a new area were edible, over millennia those instincts have programmed us to be cautious. That certainly served us well when we weren’t sure what was stalking us in the tall grass of the savanna, however, the everyday risks we face today aren’t the same.
Economists have been studying risk and particularly investment risk for a long time. In particular, I am interested in how people behave. Investment risk aversion refers to client behavior when exposed to uncertainty. When the market is up, many people are willing to take more risks than when the market is down or volatile. Part of my job is to understand how my clients think about risk and adjust their investment portfolio accordingly.
Many of us, especially parents, misprice risk in just about everything we do whether it’s falling off a pile of rocks or sticking to their investment plan.
The reality is that the likelihood of your child falling off a pile of rocks or playground equipment and actually hurting themselves is probably low depending on their age and level of coordination. Sure they’re likely to fall but not so hard that it becomes a catastrophic event beyond scrapes and a bruised ego. Beyond that, humans learn by failure, not success. For investors, the risk of missteps early in life may help those investors retool their strategy or hire an advisor.
Miscalculating risk later in life, however, may have adverse effects on those investor’s outcomes. A recent Vanguard study showed that Vanguard clients that made material changes to their asset allocation during the Great Recession lagged those that didn’t by 8% annually. Why? Humans make irrational decisions especially about the future.
Part of me thinks allowing our daughter to fail is just part of how we are parenting and that if we protect her too much, she would be less likely to take bigger risks when she is older and no longer in our care.
Every older generation likes to joke about walking to school uphill both ways in the snow or not having helmets and building ramps for skateboards and bikes out of extra throwaway lumber. As a kid my brother and I would jump off the roof of our house with my friends using a sheet as a parachute. Clearly I was mispricing the physical risk but because we never got hurt we discounted how dangerous that activity really was. In college, my friends and I would mountain bike some pretty crazy trails but because I was older, I started to put a price on breaking bones. There were certain parts of trails that I would just walk down. Throw in your own childhood experience.
Parents of every generation redefine risk for their kids and because society seems to be moving faster, that parental definition is speeding up as well. In the investment world, our risk cycles have sped up due to the 24 hour news cycle, hedge funds, high frequency trading, faster technology, and globalized markets, these and other factors contribute to the noise surrounding investing
The same really goes for our investment portfolios when we think about risk.
Let’s face it, most of the time we misprice risk. After spending the last 12-15 years working with my clients to worry less about the downside of market volatility and to focus instead on fundamentals of investing. Typically when the market enters a correction, defined as a drop of between 10% and 20% from the market high, volatility lasts on average about three months. It’s a very short time to be concerned about the overall return in any given year or in any given market cycle and yet, many people worry about market when volatility rears its ugly head. Which brings me to risk and perceived risk.
Risk and Perceived Risk
Most of us are currently mispricing risk in our portfolios. Some of us utilize the ostrich method, we bury our heads in the sand and hope that it comes out okay. Others are far too conservative based on irrational fears about the stock market or not understanding the investments that they hold. Even some financial professionals don’t necessarily know the amount of risk their clients are actually taking in their portfolios.
Blue Dot Wealth Management uses both software and risk strategies that help us construct portfolios tailored to the individual based on their plan. We find it common with prospects and new clients that they typically taking more risk than they think or conversely that they aren’t taking enough risk to meet their goals
Whether you’re investing for your financial future or playing with kids or grandkids at the park, risk is everywhere. It’s just a matter of figuring out how much risk you’re willing to take and finding a financial advisor who can help guide you through it. Interested in learning more? Contact Blue Dot Wealth Management today.