How Much Risk Should you Take? Part 1

Asset Allocation: Part 2

Imagine you woke up tomorrow and you had lost half of your retirement savings. How would you react? How would you feel? More importantly, what would you do? If you’re like me it would probably be some mix of sheer panic, intense anger and projectile vomiting all at the same time. Once that subsides a few days later it is time to make some decisions.

Which would you do?

1.) You sell everything to prevent future losses. Better to cut my losses now than to keep bleeding isn’t it?

2.) You get angry, complain, call your financial advisor and scream at them in an effort to make yourself feel better, but you do nothing else. You do not trade at all. After all, I’ve already lost this much, it can’t get much worse, right?

3.) You check your bank account and savings accounts, pull together every extra dollar that you can spare and you go and buy as much equity as you can. After all, there’s no better time to buy than when stocks are on sale, right?

Whichever of the three scenarios is most likely to be you, your answer to the thought experiment says a lot about your risk profile.  But coming up with one you can live with through the ups and downs of the market can prove rather elusive. Mainly because our brains love to lie to us about how we really are. We love to think we can handle it. We won’t sell. We’ll buy. Until it happens. And we are dropping F bombs as our advisor is trying to remind us that we agreed to the portfolio we are now wanting to chuck off a ten story building.

Swooping in to save the day are firms and financial advisors with their questionnaires. Oh how lucky we are. The way that many firms and advisors have tackled this risk profile dilemma is by having their client answer a series of questions aimed to determine how they are able to handle risk. Questions like,

“If the market dropped 10%, what would you do?”
A. Buy
B. Sell
C. Hold.

Or

“When I invest my money, I am most concerned about:”
A. My investment losing value
B. Equally concerned about my investment losing or gaining value
C. Most concerned about my investment gaining value

This sounds great in theory… Just answer these questions and we will tell you exactly what your risk tolerance is. The problem: IT DOESN’T WORK.

In the Book ‘Your Money and Your Brain’, Jason Zweig quotes a study where they had 100 different people take 6 separate questionnaires. The similarities between the results of the 6 was only 56%. So basically a questionnaire has the same probability of being right as a roulette wheel does. Maybe instead of trusting a multiple choice document we should all just head to Vegas!!!!!!

The study goes on to say that mood is the major determining factor in risk tolerance. How you feel at that moment has a far greater impact on your behavior than anything else. If you are in a bad mood, you are likely to want to take less risk, so you may sell. If you are in a good mood, bring it on, you will likely hold or potentially even buy.

Depending on the day a 20% loss may not seem like a big deal. You just got a promotion at work, you know you will be making more money and so you see this as an opportunity to buy. On a different day the 20% loss may seem like the end of the world. You just found out someone close to you is dying and your own mortality is now staring you right in the face. The thought of losing more money is something you can’t handle, so you sell. Notice how the risk profile questionnaire had no bearing on either decision. And it was unable to predict either of them. At the end of the day, according to the science, our moods rule more than our reason.

This is an AMAZING FINDING! And a testament to the irrationality of decision making. However, it is a finding that is easily eliminated. It seems that simple awareness and knowing this is how your brain works allows you to side-step all of your evolutionary baggage and make a more rational, emotionless decision. And this seems to be the case immediately (as soon as you know or remember.)

And now you know!  But this knowledge leads to more questions. Namely, if questionnaires suck because they are dictated more by our moods than our reason, what is a good means of determining a proper risk profile?

While the best indicator may be to go through a 2008 market crash and see how you react at the bottom of it, I’m guessing none of us want that. So then what else is there? We will discuss some simple, practical determinants next time but for now I’ll give you a sneak peek because you’re still with me 900 words later. The magic secret to risk doesn’t turn out to be so magical at all. The best determinants are going to be your age and life situation. That’s it. Simple, boring, but effective. We will get into the details of it next time.

Please note: I reserve the right to delete comments that are offensive or off-topic.

Leave a Reply

Your email address will not be published. Required fields are marked *