Investor risk is as crucial as investment risk

Living Money founder Jeremy Deedes consider that investor risk and our behaviour are as important as the investments themselves and that the regulatory approach to risk is fundamentally flawed..

Investor and investment risk

by Jeremy Deedes | Living Money

I want to address the subject of risk in investing. This is important as you start to implement you plan. Misjudging risk can be the death of a good financial plan so its important to give serious consideration to this.

The key question is – where does risk lie? For the regulators and most individuals, risk is seen to lie in the financial product, the investment. Huge amounts of work are done on risk rating products, explaining the likelihood of a product failing, or failing to perform as expected, and the consequences of such a failure.

Its a very mathematical, logical approach and its fairly simple for product providers to quantify the risk of failure and indeed the probability of success. And indeed, its important to do so.

However, we probably don’t spend enough time or effort on assessing the other side of the equation, the risk that lies in our own psyche as investors.

True, regulators around the world require financial advisers to assess the clients ‘attitude to risk’ and ‘capacity for loss’. There are a number of risk profiling services that use psychometric questionnaires to come up with a score and a risk profile. Once again, however, these tend to be formulaic and based around numbers rather than emotions.

Typical questions are:

  • How much of a fall could you tolerate before becoming uncomfortable
  • How much risk have you taken in the past
  • What does ‘risk’ meant to you

These are all designed, as the name implies, to assess you attitude to risk, thereby allowing advisers to match the investment risk profile to the investor risk profile and say that Product X would be appropriate and Product Y not.

However, I think we need to go much deeper than that and assess our own behaviour as investors. Carl Richards, an American financial planner and cartoonist, advocates in one of his drawings that the investor causes more damage to portfolio performance than the economy and markets combined.

He describes how, irrespective of their attitude to risk, investors pile in to stock markets as they rise and sell when they crash as their decisions are driven by the those two powerful emotions of fear and greed. A rather more logical and emotion free attitude was taken by financier Nathan Rothschild who in 1810 advocated buying when the cannons roar and selling when the violins play – which is why he was a multi-millionaire and most investors are not.

And we can take this to an even deeper level than simply the influence of our emotions. The degree to which we are extroverts or introverts has a significant impact on our investment decisions. Psychologists have identified a phenomenon called ‘reward sensitivity’. A reward sensitive person is highly motivated to seek rewards, whether they be financial or other types.

In her book, Quiet, Susan Cain describes the work of financial psychiatrist Dr Janice Dorn who has observed that extroverts are more likely to be reward sensitive whilst introverts are more likely to pay attention to warning signals. Often extroverts can be too reward sensitive. Cain quotes the case of a 60 year old client of Dorn’s who consistently put money into an investment subject to a bailout in 2008, in spite of never having participated directly in the stock market during his working life. The client eventually lost a staggering $700,000 because the danger signals had been there and he had ignored them, blinded by the prospect of the ultimate big win – which never happened.

Notwithstanding the client should have never had such a high exposure to a single investment and should have been more careful with his life savings, the story does illustrate that the risk warnings and risk profiles do not necessarily capture the consequences of our behaviour, especially in high octane situations.

Hence the burgeoning science of behavioural economics which challenges the notion of the rational investor (the notion on which most product and investor risk profiles are built). As commentator Rory Sutherland says, we are still operating on the 100 year old neo-classic model of economics – and that leaves out the real drivers of life and finance, namely trust, psychology, context, relationships and ethics.