Are You Being Honest With Yourself About Your Risk Tolerance?
From 2009 until the end of 2018, investors enjoyed the longest bull run in US history. This run lasted over nine years and paved the way for the S&P 500 to average over 15% in annual returns. Then in December 2018, the markets had its worst performance since 1931.
Investors began to worry of a potential recession and the effects it would have on their future financial goals. The panic that accompanied the market downturn was a complete change in direction from the more stable reactions in previous years when markets were steadily on the rise.
The stark contrast in market environments should be a wake-up call for more cautious investors, who had received substantial portfolio returns by investing in high returning asset classes. Because of the consistently positive market returns, the higher volatility associated with the higher return was a non-factor for many investors.
Typically, investors will determine the target rate of portfolio growth or return they need to reach a goal and interpret their risk tolerance based on that target. This presents a problem when investors aren’t seeing the returns they need, and instead are feeling the negative effects of the volatility in the portfolio.
An investor’s anxious reaction to the flashing red numbers in their portfolio should be a signal for them to conceive a portfolio structure that isn’t as emotionally taxing. To do so, they should look at determining the risk tolerance from the other direction and ask how low they would be willing to let the portfolio fall.
The Cold Hard Facts
After becoming accustomed to the profitable market environment during the recent bull run, investors likely overestimated their risk tolerance and didn’t find it necessary to account for the risks associated with higher returns. This posed little to no problem when markets were booming during the last nine years because investor portfolios reaped the benefits. It wasn’t until the end of 2018, when over 90% of all major asset classes recorded negative annual returns, did investors begin to reconsider their true risk tolerance.
Allocations to securities with higher volatility can lead to higher potential returns over long periods of time, but it also means potentially increasing one’s risk tolerance. From 2003 to 2018, the most volatile asset classes produced the most return for investors willing to take on such risk.
In the table provided, one can see the top three returning asset classes; emerging markets, REITs and US small caps are also the three with the highest market volatility. Therefore, they have the highest average returns, but have wider ranges in performance.
For example, REITs had a 35.1% return in 2006, but had -15.7% and -37.7% returns in the following two years before having a return of 28.0% in 2009. This tradeoff between high returns and high volatility is something investors needs to be conscious of when assessing their true risk tolerance and making long-term investment decisions.
The perception of consistent above average or above market returns for a portfolio can grab the attention of any investor, but the increased level of risk needs to be accounted for. There are useful, but not absolute, metrics one can use to quantify the risks in the portfolio.
For example, betas and durations are the relative performance of equities and fixed income securities compared to the S&P 500 and interest rates set by the Fed, respectively. Standard deviation quantifies risk by measuring the extent of fluctuation in a security’s return from its historical mean. These metrics not only illustrate how far up the investments can go, but also how far down in certain situations.
An equity investment’s beta presents how much the security overperforms or underperforms relative to the S&P 500, which has a beta of 1.0. The higher the beta, the higher the potential upside and potential downside. An investment with a 1.5 beta means it is a potentially riskier investment with its performance more likely to be 1.5x higher or lower than the S&P 500’s.
With fixed income investments, duration is used to illustrate the performance based on the current interest rate that is set by the Fed. For every 1% increase or decrease in interest rates, the fixed income investment’s price decreases or increases by its duration.
When using the standard deviation of a security, the underlying assumption is that the majority of price activities follow a pattern of normal distribution. It takes into account the deviation against the mean in either direction; a higher standard deviation indicates larger possible separations from the mean, and a lower standard deviation indicates smaller separations. Therefore, higher volatility implied by a higher standard deviation can lead to greater possible returns, and also the possibility of greater losses.
Behavioral Economics of Investing
By researching the average returns of asset classes and the risk metrics associated, investors can gain a better picture of how their portfolio should perform. It’s usually in situations with unexpectedly low portfolio returns that an investor may feel panicked and act irrationally. This behavioral component of the general tendency for investors to make impulsive decisions in such market conditions is explained by the principle of loss aversion, which was theorized by a study done in 1979 by Daniel Kahneman and Amos Tversky.
The basis of loss aversion is the idea that people dislike losing money more than they like winning money. In the study, Kahneman and Tversky focused on two groups of investors; the first group monitored their portfolios on a monthly basis and the second group on an annual basis. The first group moved into more conservative portfolio allocations than those chosen by the second group, because the first group was more likely to see losses in their portfolios. This led them to lower their risk tolerance and taper down the potential return of the portfolio to avoid potentially greater losses.
A perfectly objective and rational investor should theoretically be just as positive to a 1% gain as they would negatively to a 1% loss. However, the principle of loss aversion proves that to be false. The first group felt more pain from losing money than the pleasure from winning money. The important fact to note is that the loss aversion theory can help investors understand their own behavior and the level of risk acceptable.
You and Your Portfolio
An investor’s risk tolerance is a crucial aspect of how a portfolio should be constructed and what financial goals are obtainable in the future. The next time your portfolio experiences a downturn and causes you to panic, take a moment to review your portfolio. Is it constructed with riskier securities in mind? How comfortable are you with the return of the portfolio, given the level of risk? Are you able to objectively analyze your investing behavior in certain market environments? Are you being honest with yourself about your risk tolerance?
Given that emotions can run high in investing and can cloud your judgement when answering the questions mentioned, you should look to an outside party who can provide candid guidance. Reaching out to your financial advisor can be instrumental in how you structure an allocation that is best suited to help you reach your goals while keeping you levelheaded given your risk tolerance.