Don’t misjudge risk tolerance

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.

“Markowitz is a very smart man. He’s smart in many different ways, one of which is, of course, his knowledge of mathematics and programming. He also understands investors very well. He understands, for example, that while his framework is about optimizing the portfolio as a whole and having a global attitude towards risk, it’s something very few people can actually follow,” Statman says. “A portfolio is not one big block. There is money for retirement; there is money you want to leave for your kids; there is money you want to direct for grandkids or college educations or there may be a disabled child you need to support. People have all types of goals.”

The research found you can create individual, self-contained portfolios for each goal, each with its own risk profile. Cumulatively, the total portfolio of portfolios will lose very little efficiency if each bucket is created following the tenets of modern portfolio theory.

Statman explains the concept further, using an example in which a 65-year-old investor intends to be fully retired at age 70. Retirement income is his most important goal. Most likely, you would want to have a near bulletproof bucket for this goal, which has only a five-year time horizon. Other goals, such as bequests to charity, etc., could be put into riskier assets.

“Let’s say you created that portfolio in October of 2007, when times were still relatively good. Let’s say there’s a 95% chance you’re going to hit your retirement goal. There is a 70% chance you are going to meet your education for the grandkids goal. There is a 30% chance you’re going to meet your bequest goal,” he says. “In our current market, when you look at the different buckets, you realize that the bequest bucket has been shattered. The likelihood of that [goal being met] is 5%; the likelihood of the college education goal might now be around 50%, not 70%, but you can see if you timed it right, the retirement account is still 95%. Your client sees they’ll make it. I think that this makes for a much better conversation and overall client position.”

Statman says to create these buckets also requires doing a much deeper behavioural probe. For example, one of the things he wants to determine is whether an investor is overconfident, rather than risk averse.

“When somebody says they can take risk in a questionnaire, is it because they can take risk, or is it because they are stupid enough to believe they have superior stock-picking abilities and are therefore overconfident? That can happen in periods of exuberance. Investors think they are geniuses, that there are no risks; what’s to be averse to?”

Now that some of these psychological tendencies are being exposed in investors, new opportunities are being created to study behavioural finance. Lisa Kramer, behavioural finance expert and associate professor of finance at the University of Toronto’s Rotman School of Management points out that this field of study is relatively young, and the market downturn is a tremendous learning opportunity to see how investors react to declining wealth.

“There has been some discontent with the conventional mainstream financial models out there,” she says. “There is a surge of interest in developing models that incorporate behavioural elements into financial decision making. I’m certainly getting a lot of calls. The field of finance is more open to behavioural explanations for financial market phenomenon. I think we’ll see even more of that.”

One of the growth areas is a sub-field of study known as “neuroeconomics,” in which researchers map out the physical parts of the brain used in financial decision making.

“Researchers are actually putting people into functional MRI machines and having them make financial decisions as their brains are being scanned. We’re learning at a much more primitive level about how financial decisions are made in the brain,” she says. “The research is finding there are particular regions in the brain involved in making riskier decisions, and regions that are involved in making safer decisions. As we develop a deeper understanding of that, we will have a lot more to say about how human psychology influences human financial decisions.”

This article was originally published on capitalmagazine.ca.