Innovative research in the field of behavioural finance suggests that the investment industry has misjudged the risk tolerance of well-off investors.
Meir Statman, the Glenn Klimek Professor of Finance at the Leavey School of Business at Santa Clara University in California, is one of the world’s foremost experts on behavioural finance as it relates to constructing personal portfolios. Statman’s research focuses not so much on how you can build the best portfolio in terms of performance but on how you can build portfolios that best meet a investors’ specific, psychological needs.
Many behavioural finance experts will use psychology to argue against the fundamental teachings of investing, saying human behaviour is the cause of market inefficiency. Statman, though, is a great admirer of Nobel laureate Henry Markowitz, the father of modern portfolio theory. The two co-authored a paper that commingles behavioural finance with Markowitz’s model and looks at creating a portfolio model that does a better job of meeting the “real” risk tolerance of investors.
“The typical risk questionnaire asks people really silly questions,” says Statman. “The questionnaires are really stupid. Unfortunately investors think they must answer them. If you ask someone, ‘How many stars do you think there are in the heavens?,’ they have no idea—but they’ll probably still answer the question.”
Because each person has different goals—and very different risk attitudes toward each—he says there is a tendency for the person in question to try to average the risk out “in some way that has no feel or intuition to it. [They'll] give you an answer, but that answer will most likely be nonsense.”
Given that, during the market downturn, investment firms from coast to coast fielded angry phone calls from investors who evidently misjudged what they were willing to lose, Statman’s ideas are in high demand. He recently joined the investment committee board of governors at Wellington West Capital to provide ongoing investment analysis and education for Wellington West Investment Advisors and its clients.
His first piece of advice is this: Realize most wealthy Canadians have a much lower risk tolerance than they may let on. Statman’s research has determined that investor risk tolerance is, on average, extremely low.
“We all want two things in life: one is to be rich, and the other is to not be poor,” he says. “[For most people,] not being poor is more important than being rich. If people didn’t realize that before, they certainly understand this now. I think the primary responsibility of advisors is to protect the downside of their client’s portfolio.”
In a study he’s conducted, Statman says he asked clients what maximum risks they’re willing to take to increase their standard of living by 50%. He found the typical answer is about 12%.
“People expect at least a 4 to 1 ratio—50% to 12%, between upside and downside. People are pretty risk averse,” he says. “One of the things that surprised me about this is once you create the portfolio with the 12% downside risk, it ends up only being about 25% in equities and 75% in fixed income.”
Rule of thumb would suggest this is the portfolio of a 75-year-old retiree. Statman’s research with Markowitz, though, breaks up a portfolio into different buckets, each with its own goals and risk tolerance levels. Using this, he says, it’s possible to create a portfolio that adheres more closely to an investor’s goals overall.