Integrating the Psychology of Risk into the Investment Process

Investment risk tolerance discussions are done to understand how much risk investors should have in their portfolios so that allocations can be properly calibrated. The challenge is that reaction to risk is more complicated than many realize, and thought processes have significant consequences that are often not considered. There are several reasons why discussions of risk are often more complicated than they appear.

Two High-Intensity Risk Situations

One complexity is that risk tolerance isn’t a linear concept psychologically. There are two key inflection points in reaction to risk at which intensity jumps exponentially—when going from no risk to some risk and when passing a threshold beyond which the investor can tolerate the loss. We saw an example of the first after Money Market Reform forced money market funds to show small losses on paper, hurting the competitiveness of these funds against stable value funds in fixed accounts. For a segment of the population, any loss of “safe money” is traumatic.

Our theory is that reactions to increases in market loss act more like a Richter-like scale on the upper end of the risk continuum. Our qualitative research suggests that once a certain threshold is passed, panic rises dramatically. In other words, going from a 30 percent loss to a 40 percent loss may create stronger anxiety than going from 20 percent to 30 percent.

Reexamining the Value of Time

Second, investors don’t view time in a linear way. Much more value is given to the immediate future, leading to an over-reaction to market downturns for risk-averse clients. Research we did years ago showed that, while planners discount money over time, consumers discount time. Life twenty or thirty years from now has less value than life today, particularly in retirement when the later years of aging have even less value. This is critical because time reduces risk, and the market has never lost value over a 20-year period, and investors will benefit from staying the course.

Another time-related fallacy is that investors may also fail to understand asset level sufficiency over time. Despite the theory of systematic spend down and the idea of linear decumulation as retirees age, many retirees are concerned about their asset level going down and have a minimum asset level below which they do not want to go. This minimum is often not consciously realized or discussed with financial advisors.

There is evidence that people base their feelings of financial security, in significant part, on asset level, and even in old age don’t want that level to go down too far. The fallacy here is that less money is needed as investors get older unless there are bequest needs. An 80-year-old doesn’t require the same assets as a 65-year-old because there is less life to fund. They don’t face the same consequences if the market drops.

Client Strategies for Financial Advisors

There is a need to integrate these issues into the discussion with clients and perhaps with risk tolerance measurement tools. For example, it would be useful to determine what an investor’s disaster point is and design a portfolio to keep the loss under that line. While we have only examined it qualitatively, this concept could have consequences for products such as structured annuities or alternative investments with hedging strategies that take the edge off a market crash loss.

Another strategy might be to design a buffer period before withdrawals from assets will be needed and agree with clients that risk will reduce when that buffer period is reached – such as eight years before retirement. One way to reinforce this buffer period is to train the client to think backward about investment risks from the target withdrawal date. A more thorough plan could discuss asset need levels over time and design portfolios to stay above the “five years from now” asset level. This approach aims to create a “comfort zone” for the client that shifts the client from focusing on very short-term market losses.

Another critical discussion is to have investors discuss their goals for minimum asset levels as they age so that they can be integrated into a financial plan.

These discussions are important because the inability to get clients to view risk more realistically is one of the greatest challenges advisors face. Client overreaction to risk can result in premature selling in down markets, firing of advisors, and regret. Advisors need better strategies to confront this dilemma with their clients.

If you’re interested in discussing the psychology of risk and the investment process, contact us.