Risk Is A Necessary Evil

We all have our own horror stories of the financial crisis and no doubt have heard countless iterations of others’ woes. Fear causes us to do some dumb things, no question. When it comes to losing money, research that suggests a loss of a thousand dollars impacts us much more than a thousand dollar gain.  And over the past few years there’s been a 107 billion outflow from equities, a text book example of Tversky and Kahneman’s prospect theory.

By following the money we can see where the amygdala has guided many to seek their riches (or safety) apart from the evils of equities:

  • Bonds have seen an inflow of 643 billion
  • Emerging market funds had inflows of 45 billion in 2010 alone
  • ETFs that track gold have seen a 31 billion increase
  • Indexed annuities (IMHO the worst investment ever) have seen a 54 billion increase

What better way to learn about an allergy to shellfish then an all-you-can-eat oyster bar. And what better way to learn about loss aversion than to be vested heavily in stocks pre 2007. All this risk aversion out of equities, which have seen a cumulative 37% return since the outflows, (Doh!) has landed in some interesting places besides under mattresses and CDs at a local bank. I mean come on, indexed annuities!?!

I do quite a bit of work on a daily basis with self-directed investors looking to make their money work harder for them. I always start out our relationship by assessing their risk tolerance, not by filling out some overused questionnaire but through an old-fashioned “therapy” session. Yep, ask them to lay down on the virtual couch and talk away.  I ask a ton of questions, get to know them and their goals and help them define a strategy that works for them.

You see, I’m a big believer in market participation matching up with personality and lifestyle. Those that take the time to assess this correlation tend to hang around longer and remain profitable. Managing risk is key in this game yet it seems so many just jump in and participate in whatever is working at that time regardless of risk. That works, until it doesn’t. Don’t be that guy. Find out your risk tolerance before the market finds it out for you.