Risk is always with us, and cannot be eliminated. Too much in safe bonds, and you run the possibility of losing to inflation and/or outliving your money. Too much in stocks, and you may have lots of bad sleep and then make a rash change in your investments right when recovery is around the corner.
The term “risk-averse” is mentioned frequently in personal finance and the financial advisory world. It is usually taken to mean someone who shuns risk to a greater or lesser extent. As it is defined above, it means getting the same return potential with less implied risk, which is a pretty good approach if we can find that. The thing is we can’t really get away from risk, and there are many meanings for this thing we call risk.
Risk aversion also relates to a concept called “risk tolerance,” and which has some of the same perceived qualities. One could say they are the two sides of the same coin. Risk-averse could be defined as “How much risk would you like to avoid?” and risk tolerance as “How much risk can you stand?” The problem with the concept of risk aversion is that it is not a fixed quantity or value, but a fluid concept; the same is true of risk tolerance.
There is another risk concept, called “loss aversion.” This was coined by Amos Tversky and Daniel Kahnneman in an academic study that started in 1979, titled “Prospect Theory: An Analysis of Decision Under Risk.” They ultimately won a Nobel Prize in 2002 for their groundbreaking work on the emerging field of behavioral economics. One of the paper’s findings was that people tend to feel the pain of a loss twice as much as the happiness they feel in a similar gain. They labeled this “loss aversion,” and is an excellent proxy for risk aversion. I have greatly simplified the finding in their paper for today’s purpose, but that concept of loss aversion will help us understand risk in a much more helpful way.
One of the most fundamental exercises in financial planning is to assess how a client deals with financial risk. I would simply define risk as the permanent loss of money, although others define it as how volatile your investments are. The majority of advisors will either have a conversation about risk tolerance and attempt to come to some greater understanding of what the client’s risk tolerance is, or use a questionnaire to do the same. Frequently they are used in tandem. Without this understanding, it’s impossible to create the right investment portfolio or retirement income plan.
I think that both of those processes leave much to be desired. As mentioned earlier, the meaning of risk and how we feel about it can depend greatly on the current context. Risk, risk aversion, and risk tolerance are constantly moving targets. When things are going well in the markets, people can start to feel it is less risky, they are less risk-averse and their risk tolerance rises. Or so they feel.
And then when things reverse, people see the markets as riskier, are more risk-averse and see their risk tolerance as less than it was. It’s a constantly moving target, which makes it hard on any advisors or clients.
I now refer back to the loss aversion concept in prospect theory mentioned earlier. Utilizing this framework is a significant improvement in risk measuring tools. At its foundation is the finding that losses feel worse than gains feel good. While it is possible to do rash things when things are going well, it mostly happens when the markets have lost an appreciable amount of value. That is when investors abandon their long-term plan and hunker down, only to miss the inevitable turn in the markets. That is what creates permanent loss of capital.
So what can we do to negate some of the effects to our fickle attitudes toward risk? I would offer two things:
- First, your financial plan needs a stress test. This can show that investors have a good chance of reaching their goals based on the lowest level of risk that gets them there. A simple way to do this is to assume lower returns than averages suggest, but there are other ways also. Forget about how people say they feel about risk: Find the optimal level of risk and go no higher. Taking risk down may yield less money in the long run, but will typically improve probabilities of success, and lessen big drawdowns to help avoid panic moves.
- Next, ask advisors for better tools to help measure how you really feel about risk. Today you can get access to world-class risk-measuring tools at very reasonable costs.
When I had my planning firm I used Riskalyze for risk alignment of client portfolios. Their approach is based on the principles of loss aversion outlined by prospect theory. Through an if/then sequence of questions, the client arrives at their own risk level that feels right to them. They literally do this for themselves with a planner’s guidance. It makes that risk element much more real and personal, and is likely to be a better measure than other conventional methods. But there are lots of other solid planning tools that do a good job at assessing how much risk makes sense for you. Please make sure that any advisor or planner you use has the best tools, and that they can clearly explain how it will measure your real tolerances and aversions reliably.
Getting this right is imperative. The other choices aren’t great: try to save more than you reasonably can or even want to, work much longer, or take on risk that you may not be able to handle. Staying in the game and on your plan is the best way to reach your goals with good odds. It’s worth considering taking only the risk you need. As Warren Buffett has said, and I am paraphrasing, Why would you risk what you already have and will need for something you may not get and do not need? I think that’s about right.
John Kageleiry is a business writer and financial planner. Have a question for “Finance 101”? Email it to email@example.com.