Investing Advice: Assessing Your Risk Tolerance

Posted On February 14, 2018 2:10 pm

Now is as good time as any for investors to measure their tolerance for risk. Today’s investing advice provides some helpful yardsticks.

In this thoughtful piece, Morgan Housel ruminates on Why It’s Hard to Predict How You’ll Respond to Risk. 

An underpinning of psychology is that people are poor forecasters of their future selves. There is all kinds of research backing this up. Imagining a goal is easy and fun. Imagining a goal in the context of the realistic life stresses that grow with competitive pursuits is hard to do, and miserable when you can.

This impacts business and investing, where most actions require not just anticipating rewards, but anticipating how you’ll react to future challenges.

The whole idea of investing risk is imagining a future filled with potholes and assuming you will either see it coming and avoid it – “I won’t be greedy” – or anticipating your ability to accept and exploit it – “I’ll see it as an opportunity.”

I’m here to tell you: This is really hard to do. And it bedevils our decision-making.

Best Buy stock is up more than Amazon stock in the last five years.

Blackberry stock is up more than Apple stock in the last four years.

Hawaiian Airlines stock is up more than Facebook stock over the last five years.

If you’re surprised by these numbers, it’s because it’s natural to think in a way that follows the most logical path of least resistance. Here, that means assuming outcomes are driven by underlying events. Apple’s products have done well. Best Buy’s services have not. The investing outcome should look the same.

What this misses – and this is as obvious as it is easy to forget – is that investing outcomes are driven not just by business results, but business results within the context of expectations. Five years ago, we expected nothing from Best Buy and everything from Apple. So Best Buy gets a bigger trophy for showing up to the game than Apple gets for being MVP.

The point is that it’s easy to oversimplify a forecast, because important context can be counterintuitive and easy to ignore.

The same disconnect happens when you try to forecast how you’ll respond to future risks.

How will I respond to the next investing downturn?

The logical path of least resistance is assuming I’ll view it as an opportunity. Cheaper valuations! Higher future return expectations! Isn’t this what most of us were brought up to want?

But the distance between me anticipating what a downturn will feel like vs. actually being in a downturn is ten miles wide.

The easiest way to think about a downturn is to imagine a world where everything’s the same as it is today, except for valuations, which, in my dream, are like 30% cheaper than today. This is the logical path of least resistance.

It is exponentially harder to imagine a world where a downturn is caused by something that scares me as much as those who are driving valuations down. It’s even harder to imagine a world where I see opportunity but those I trust and rely on – a spouse, or outside investors, or coworkers – convincingly urge me to be cautious. And it is mental anguish to properly imagine a world where a downturn is caused by something I participated in – especially if that something made me a lot of money today. It’s easy to ignore this context when trying to anticipate the future. But it’s the single most important part of determining that future.

Daniel Kahneman makes this point when discussing how bad we are at predicting happiness. We dream about different circumstances in a vacuum while ignoring negative factors that come along with those circumstances. Dreaming about sitting on a beach brings more joy than actually being on a beach, because in the dream you’re not thinking about getting bit by mosquitos, or having heartburn from lunch, which is what happens in the real world.

 Related: Here’s How You Should Handle a High-Volatility Environment.

The same thing happens on the way up in investing. I don’t think any investor feels as good today as they thought they would if you told them ten years ago that we’d have a decade of nearly uninterrupted gains, because ten years ago it was hard to imagine what would be occupying your mind besides your gains – bad weather, or traffic, or paying taxes on your gains, or the threat of a new downturn. Jeff Immelt explained the business version of this after he left GE: “Every job looks easy when you’re not the one doing it.”

All of which is to say:

You will likely be more fearful when your investments are crashing, and more greedy when they’re surging than you anticipate.

And most of us won’t believe it until it happens.

What do we do if we’re poor predictors of our future selves?

Years ago, psychologist Dan Ariely was asked by a group of financial advisors for advice on how to better serve clients.

“The craziest thing you guys do is the risk assessment questionnaire,” he said.

The questionnaire asks clients how they’d feel if they lost 10%, 20%, or 30% of their money, and builds a portfolio off the results.

It relies on people accurately predicting how they’ll feel if they lost money in the future. Which is extremely hard to do when the economy is booming.

A better approach is using your past behavior as a guide to your future behavior.

Past behavior includes more context of how the world works than you get when trying to envision future behavior. It’s also based on the idea that how people react to outlier events – booms, busts, stress, joy – is driven more by emotions that are stable in time than intelligence that evolves over time.

How you responded to the last big loss, or the last big win, or the last stressful project, or last time you lost control of your schedule, is probably a good indication of how you’re likely to respond the next time it happens.

One of my favorite ideas is that people should read more history and fewer forecasts. That’s not just true about business and investing topics, but for ourselves as well.

 Related: Here’s How You Can Spot the Next Bubble Before it Bursts.

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Steve Smith

Steve Smith have been involved in all facets of the investment industry in a variety of roles ranging from speculator, educator, manager and advisor. This has taken him from the trading floors of Chicago to hedge funds on Wall Street to the world online. From 1987 to 1996, he served as a market maker at the Chicago Board of Options Exchange (CBOE) and Chicago Board of Trade (CBOT). From 1997 to 2007, he was a Senior Columnist and Managing Editor for TheStreet.com, handling their Option Alert and Short Report newsletters. The Option Alert was awarded the MIN “best business newsletter” in 2006. From 2009 to 2013, Smith was a Senior Columnist and Managing Editor for Minyanville’s OptionSmith newsletter, as well as a Risk Manager Consultant for New Vernon Capital LLC. Smith acted as an advisor to build models and option strategies to reduce portfolio exposure and enhance returns for the four main funds. Since 2015, he has worked for Adam Mesh Trading Group. There, he has managed Options360 and Earning 360, been co-leader of Option Academy, and contributed to The Option Specialist website.

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