Tolerating Risk

The recent market volatility, especially the kind with rapidly falling prices, gives us a reason to pause and consider risk. Risk is one half of the risk/return equation; one can’t get much of the latter without the former. The reason for this is simple supply and demand. Everyone wants high returns with no risk. But that pool of money overwhelms the demand for it. So, money demanders, companies seeking capital through selling stock can lower their cost of raising capital by introducing price risk. They simply won’t guarantee that the original investment will get paid back ever. Stock buyers who are later sellers are forced to find fickle buyers in the market. Therefore, the most conservative potential investors drop out of that marketplace and the supply of money from risk-taking investors approximates the demand.

But if one is an investor and not merely a risk averse saver how much risk should one take? One way to determine this is to find one’s pain point: the amount of loss that one just can’t stand. Not knowing this pain point can result in the worst of all possible outcomes – buying and then selling low when the loss is too much to bear only to see the stock completely recover in price. Knowing one’s pain point is vital and the stock market can be an expensive place of discovery.

Behavioral researchers have spent considerable energy investigating individual risk tolerance. One of their key findings is that gain and pain are not symmetrical, that is the happiness from one unit of gain often doesn’t equal the pain of one unit of loss. In fact, as reported in a recent Wall Street Journal article (“Why Fund Ratings Could Be Misleading for Many Investors”, February 8, 2016, p. R1), for a typical person it takes a little more than two units of gain to balance one unit of loss. While the authors of this article aren’t critical, many observers take this imbalance as a sign of irrational behavior from emotional and shortsighted individual investors. But is this fair?  Consider the following.

A person is not a pension fund and the investment habits, and even the arithmetic, that grew out of the pension world, with thousands of participants in an everlasting institution, sometimes don’t apply to individual people. Even something as simple as an average can have different results. For a pension fund returns usually average out in a small range between pretty good and a somewhat disappointing. But in the individual world events are much wider ranging: the average of hitting the lottery and death is not an OK day. It is death. Every successful gambler knows to protect his stake above all else. Once it’s gone the game is over no matter how many sure future gains are staring him in the face.

Likewise, the pension fund with thousands of assets has the luxury of trying investments with a chance at amazing returns and the significant possibility of absolute loss. The researcher looking down from on high on 100,000 investors may declare a strategy reasonable that causes 95,000 to hugely prosper while 5,000 go bust. But the 5,000 busted investors would beg to differ.

So, feeling a loss more than twice a gain is not irrational. It is simply understanding one’s status as a human being, trying to make one’s way through a varying world, eking out better returns to end up better off. But do all investors feel loss and gain in that two to one ratio? It turns out not. Some feel dramatically worse with loss than happiness with gain. Some balance the two. And just under ten percent of people feel more from gain than from loss. Knowing one’s own ratio can be helpful in determining a successful allocation between risky and safer assets and enhance the chances of long-term investment success.

Turning again to the article cited above, Professors Shlomo Benartzi of UCLA and John Payne of Duke University have developed a method of estimating one’s risk tolerance through a simple ten question quiz. In each question two bets are proposed, with a 1/3 chance of gain, 1/3 chance of nothing happening and 1/3 chance of loss. The test taker chooses one and then the next pair of choices are presented. The size of the gains and losses are varied throughout the questions. By tending toward one kind of bet over another the software estimates how more loss hurts than gain pleases and expresses it as a number. You can try this quiz at digitai.org/#lab. We’d be happy if you shared your result with us.

http://digitai.org/#lab