Investor Behavior In Volatile Markets
April 24, 2016
Volatile stock markets create conditions that can interfere with investor decisions. Learning how to recognize cognitive biases and understanding financial behaviors can help investors manage emotions and deal with negative financial and geopolitical news. It’s important for investors to realize that their stated risk tolerance often changes based on market conditions, leading to sub-optimal reactionary decisions.
What Is The Difference Between Risk Tolerance And Risk Capacity?
An investor’s overall risk profile consists of separate components, risk tolerance and risk capacity. Risk tolerance is a pain threshold or sleep at night quotient. Risk capacity is the amount of financial loss an investor can withstand in a worse-case scenario.
Risk tolerance can be described as the pain threshold beyond which the investor begins to suffer an emotional loss. Risk is often assessed by a questionnaire asking how much financial loss you can endure before making a change. Here are examples of some typical investor risk profile questions:
On a scale of 1 to 10, what is your risk tolerance?
The investor answers “6” in an ordinary market, then changes to a “9” in a bull market and a “2” in a market correction.
What is the maximum loss you feel comfortable with?
This question is often asked in either $ amount (e.g. down $50,000) or % terms (e.g. down 20% in one year).
Which of these hypothetical portfolios would you choose?
Investors are shown three choices with high, moderate and low risk and corresponding returns.
It’s important to evaluate qualitative (emotional / feelings) information rather than merely relying on quantitative data, i.e. “the numbers”. If a client says they prefer a low risk portfolio, but expects 7-10% average annual returns, there is an inherent disconnect. Here is a favorite question at Coherent to help provide better client-advisor accountability and communication:
When you hear the word RISK, what is the first thing that comes to your mind?
People often answer a question “correctly”, meaning they know what they should do in a given set of circumstances. However, when the investor is under duress during a market downturn and exposed to negative market sentiment, poor financial and geopolitical news, their actions can be quite different.
“The general issue is that people answer questions in the way they hope they would react, rather than how they really do.”
Risk Capacity: Considering the investor’s acceptable risk tolerance level, can they actually endure the potential financial loss? For example, during market up-trends, people often overlook the possibility of a 20%+ decline in their account values. If this decline happens, can they still maintain their same standard of living, or will they need to make significant adjustments?
What Are The Components Of Risk Capacity?
- Length of Time Horizon: The longer the time horizon, the higher the risk capacity
- Amount of Capital Assets: The lower the capital base, the lower the risk capacity
Let’s review these two components. Young investors with decades until accessing retirement funds have a higher risk capacity. The market fluctuations are not of primary concern while they are systematically adding to retirement plans such as 401k, 403b, traditional and Roth IRAs. However, a retiree without the benefit of continuing earned income and the ability to add to retirement plans has a reduced risk capacity compared to the young investor.
Investors with limited available capital assets have a lower risk capacity. If you have no cash reserves for immediate needs (e.g. an emergency fund or money needed for any near term financial goal), then you shouldn’t expose these assets to potential negative returns. For example, let’s assume you need $20,000 as a down payment on a house expected to be purchased in the next three to six months. Do you want to risk turning $20,000 into $18,000 when you need to close on the house if there is a 10% decline in your investment?
How Does My Human Capital Affect My Risk Profile?
Human capital is an important concept in an investor’s risk profile. A person possessing a high demand skill set with high earning potential over a long career has an increased risk capacity. For example, healthcare sector individuals such as physicians and dentists, biotech and pharmaceutical professionals, or information technology workers with advanced knowledge and acumen may enjoy significant income and additional compensation opportunities such as restricted stock units (RSUs) or stock options.
On the other side of the equation and somewhat counter-intuitively, salespeople, entrepreneurs, and business owners who are subject to wide swings in economic stability or income predictability may experience periods of low or diminished risk capacity.
How Do Behavioral Finance And Cognitive Biases Affect Investors?
Behavioral finance is a field of study that combines behavioral, cognitive and psychological theory with economics and finances to help explain how and why people make non-rational financial and investment decisions. As discussed earlier, while investors often “know what they should do” during times of market distress or market euphoria, they often react in a sub-optimal manner.
Cognitive biases are rooted in human tendencies to think and process information in certain ways. A cognitive bias is a systematic error in thinking that affects the decisions and judgments that people make1. When we need to use some form of judgement when making a decision, our tendency is to think we are logical, rational and processing all available information in coming to our conclusion. Unfortunately, our judgement and decision are thrown off track by a multitude of biases. Here are three common cognitive biases that affect investors:
- Overconfidence Effect
- Loss Aversion
Anchoring is the tendency to place excess emphasis and rely too heavily on one aspect or piece of information in our judgement. Often this piece of information “anchors” our perception when making a decision. An example of anchoring is when investors are seeking “yield”, that the interest from bonds can be similarly replaced by owning dividend paying stocks. For example, investors who are anchored on income production while the 10-year Treasury is yielding 1.7% think they can own a common stock yielding 3% without incurring additional risk. Equity risk with stocks, even dividend producing stocks, is significantly higher than a Treasury note.
Overconfidence comes from an individual’s certainty in their own answer to a question. People may “feel” that they are 90+% correct in their answer when the actual percentage is significantly lower. Overconfidence can also overlap with recency bias, a tendency to think that recent trends or patterns will continue in the future. So when the stock market has been bad/good recently (and the media is incessantly reporting the news), the investor inadvertently becomes more “confident” that this trend will continue.
Loss aversion relates to the negative feeling of a loss outweighing the pleasure of a gain. Various studies have shown that people feel twice the pain from a loss compared to a similar gain. This creates a disease that I call “get-even-it is”. When an investment or portfolio goes down in value, the person says to themselves, “as soon as I get back to break even”, I’m going to sell.
A good question an investor should ask themselves is, “If I didn’t own this investment today, would I buy it?”
At Coherent, our investment process and philosophy helps eliminate the “white noise” from media and other sources that can negatively impact client’s decision making process. Thank you for your interest in our material and always feel most welcome to contact us with any questions or for additional information.
Tom Pietrack, CFP
April 24, 2016
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- “What Is a Cognitive Bias?” www.verywell.com 2/5/2016
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