Investment risk and penalty points

As an investment adviser, the starting point for all investment advice is understanding each client’s tendency to take risk as well as their tolerance in accepting possible losses. From an adviser’s perspective the nightmare scenario is a client who tells you that he/she is prepared to take risk in order to possibly get large gains yet is the first to complain when markets go in reverse. Investment Risk is apart of the process but not the central compass.

As could be seen from the demise of the Celtic Tiger many investors were prepared to take risk in bull markets only for their low risk tolerance to be seen in bear markets. Surprisingly, research coming out of the 2008 financial crisis shows that even if client willingness to take risk may change their risk tolerance remained stable both before and after the bear market. The takeaway from this is that the problem of investment clients becoming difficult or reticent in volatile markets is not a problem of risk tolerance, but one of risk propensity.

The distinction between risk propensity and risk tolerance is relatively new for most advisers. Put simply, risk propensity is a measure of an investor’s willingness to accept higher risk or volatility in exchange for the possibility of higher potential returns. Risk tolerance is a measure of an individual’s willingness to accept an uncertain and possibly unfavourable outcome in pursuit of a better result. While they seem similar, understanding the difference is crucial for both investors and advisers.

Rather than focus on investment terms, let’s look at the issues in a different way. Let’s say you’re driving on a motorway where the speed limit is 120 km, but you’re driving at 130km. This means either by deliberate or subconscious choice, you’ve decided that you’re willing to risk a speeding fine and penalty points (on the basis of a small chance of being caught) in exchange for getting to your destination a few minutes faster. You’ve made a behavioural decision about the risk/return trade-off—that the small chance of a fine and penalty points is worth getting to your destination a few minutes earlier —this is all based on your risk propensity.

Further on down the motorway you actually drive by a Garda car that has just pulled in another driver. Even though the Garda is not aware of you, you start driving a little slower for the next few kilometres, even though you didn’t get stopped. Why? Because you’re reminded of the fact that you could get stopped and there could be another Garda car on the motorway ahead of you. What just happened is that you exhibited what is referred to as “recency bias”. You have over-weighted the probability that whatever happened recently will happen again soon. As a result, you suddenly think the risk of getting caught for speeding is not a small chance but possibly far larger than it might in reality be. So in response, you have modified your behaviour and drive slower. What has changed is not your propensity to take risk but the actual tolerance of being caught for speeding.

In an investment context everyone who invests is similar. We have an inbuilt propensity to take risk until something happens which reminds us of our tolerance in taking losses. Knowing how both traits are experienced by a client is fundamental to arranging a portfolio structure for each client. Not only is it vital that a client has a portfolio that is in sync with their goals and ability to maintain a portfolio going forward but it is essential that if an adviser is to be able to stay in business that he/she is beyond reproach in their investment advice methodology. There is only one solution. Advisers must dig deeper into their clients risk traits. Not to do so could potentially be financial Armageddon for the client and business suicide for the adviser. Investment Risk can be managed.