Are you more concerned with the likelihood of losing a portion of your hard-earned savings? Or, if you’re just starting out, is it the uncertainty of achieving that expected rate of return that bothers you more?
First off, it’s important to recognize that all of us have different risk levels for different investment objectives, says University of Chicago professor Richard Thaler. And these levels change frequently.
Mr. Thaler has found that, like gamblers, investors tend to take more risks when they feel they’re ahead of the game. And, on the back of rising commodity prices, Canadian investors have certainly been feeling pretty good about themselves recently.
In experiments, some people were given $30 to work with while others were given nothing. The first group, Mr. Thaler observed, gambled more often when offered the chance to flip a coin for $9 where heads meant a loss of $9 and tails meant a win of $9 than those who were risking their own hard-earned money. In this instance, 75 per cent chose to gamble.
In the second experiment, each person had the choice between flipping a coin and getting $39 for heads and $21 for tails or keeping the $30 by not flipping the coin at all. Although the expectation is exactly the same as in the first experiment, this time, only 43 per cent chose to gamble, with the remainder opting for the sure thing since it was now in their hands.
In other words: Once you can touch it, you don’t want to lose it.
Emotions often cause investors to react in strange ways, particularly when they think they should “do something” to protect themselves from perceived risks to their nest egg. Establishing strict risk guidelines far in advance will help these folks stay disciplined when the markets are volatile, says Mr. Thaler. And that’s probably where we are right now.
The key is to gauge and budget your appetite for risk efficiently, says James H. Gilkeson, a professor at the University of Central Florida. Here, your objective is maximizing what professionals call “alpha” - the extra return in excess of a benchmark index like the S&P/TSX Composite - while not taking on much more risk. This risk-budgeting process has three components: How much risk am I taking? Is this an appropriate amount? Where should I spend my risk allowance in the future?
First, he suggests, investors should choose a passive, long-term benchmark portfolio – the traditional 60/40 per cent split you see in a lot of balanced funds, for instance. You then must have good cause to deviate from that benchmark, either because of current economic or investment conditions, or because you believe you can select superior investments or managers within an asset class, which is really tough to do. In other words, try and find your comfort zone up front and then stick with it.
Emotions often cause investors to react in strange ways, particularly when they think they should "do something" to protect themselves from perceived risks to their nest egg. -
Risk budgeting is related to but not quite the same thing as the “value at risk” approach used by big institutions and often adopted by older investors. By assuming you care about the likelihood of the really big loss, VAR tries to answer such questions as “What is my worst-case scenario?” and “How much could I lose in a really bad month?”
These are usually expressed either in dollar or percentage terms and help set a threshold for the portfolio, outlining a maximum amount that you’re prepared to lose.
If all this seems a bit esoteric, Ohio State University researcher Sherman Hanna says he has a more practical way to help calculate how much risk you can shoulder.
Looking at economic theory about risk and regret, Mr. Hanna developed a series of questions forcing people to choose between scenarios that offer varying amounts of trouble.
For example, one question asks respondents to choose between two pensions: One provides a guaranteed income equal to what you were making prior to retirement. The other has a 50-per-cent chance of doubling that and a 50-per-cent chance that you’ll end up with 20 per cent less income than you had before you started.
Questions like this can be difficult to understand if people are asked to keep the numbers in their heads, Mr. Hanna feels. So he experimented with presenting these options graphically, showing potential increases or decreases in net worth resulting from different decisions.
Unlike some of the questionnaires used by fund companies, this approach produces more useful real-world results, he maintains. Most respondents end up with risk-tolerance levels consistent with a stock-heavy portfolio until middle age, with stock allocations decreasing to about 40 per cent by retirement.
To see where you might fit, you can
take the survey online at http://hec.osu.edu/people/shanna/risk/invrisk.htm
