A while back I wrote a piece on the three facets of risk, focusing on the need, the ability and the willingness to take risks.
It is the willingness part of the puzzle that can prove vexing for financial advisors—and can be the undoing of individual investors who fail to appreciate it. Because one’s willingness to take risks can be unduly influenced by factors that should have no relevance to the question of how willing one is to taking risks!
Anyone who has ever filled out a “risk tolerance” questionnaire knows how difficult they can be to answer with precision. “On a scale from 1 to 10, how much risk are you willing to take to achieve a higher return?” (oh yeah, and 10 equals “a lot,” does that help?!). Absent any context, it’s a brutal question to answer.
Even with context it’s hard. In fact, sometimes context itself can make the question even more elusive. Enter the “recency bias.” The recency bias is the tendency to think that trends and patterns that we observe in the recent past are likely to continue into the future. Such biases block the ability to buy when stock prices decline and sell as they rise—because the recency bias leads us into thinking that down markets will continue to go down and upward trending markets will continue to rise.
Ask yourself how much risk you are willing to take after many consecutive months of a rapidly rising stock market, and you will come up with a far different answer to the identical question if the market had tanked the previous year. Neither answer is right. Or, perhaps, they both are right.
Folks sell at the bottom because they are convinced the market will continue to decline, and they fail to sell near the top because of the inaccurate belief that the market will just keep on rising. The “buy low-sell high” maxim is a wonderful theory, but real-world biases such as this one make it exceptionally difficult to implement in the absence of a plan!
Defining all facets of risk is such a critical aspect of building an investment portfolio, yet the very definition of risk changes constantly, and it's often easier for an objective outsider to help us see the truth without bias.
Interested in learning more? Anything written by Paul Thaler (The Winner’s Curse) or Daniel Kahneman (Thinking, Fast and Slow) are fascinating looks into this and other biases that can make managing one’s own money so very difficult.
You are always welcome to contact me to discuss these and other issues that impact your financial health. I'm always available to help.