Risk tolerance is emotional and can’t be measured easily

May 22, 2024
Written by Felix Narhi
Risk tolerance is emotional and can’t be measured easily

As seen in the Globe & Mail on May 16, 2024 (for subscribers only)

In the professional sphere, investment risk is defined in technical terms with mathematical ratios, such as standard deviation, Sharpe Ratio, Beta, R-Squared and so forth. These can be useful tools. In addition, each type of asset class has its own peculiar risks. For example, equity investors must understand the “trinity of risks”—business, valuation, balance sheet—of the individual enterprise. There are also risks associated with industry sector, geography, market capitalization, and so forth. Fixed income investments have interest rate and default risk among others. These can all be categorized as analytical risks and are important. However, even the father of security analysis and quantification Benjamin Graham observed “The investor’s chief problem – and even his worst enemy – is likely to be himself.” It’s not the analytical mistakes and risks that derail investors. It is psychology that usually that matters the most. 

For most investors risk is, first and foremost, an emotional experience that cannot be easily measured analytically — but is all too real. Risk tolerance questionnaires which serve as guiding documents to delineate how much financial risk a person is willing to assume and the suitability of certain types of investments can give a false rating. Feelings of higher risk comfort levels are more likely to occur in tranquil periods or a bull market. It’s only during periods involving tail risks, such extreme and unpredictable events as the Covid pandemic in 2020 or the Global Financial Crisis in 2009, that an investor can discover their “true” risk tolerance.  

These types of extreme events trigger panic selling. If this results in capital losses and breaking the compounding cycle, it becomes a major risk. Time and time again, investors sell into falling markets and many struggle with the decision of when to return. The ease of online trading that enables investors to transact on their mobile phone with just a few clicks, makes it more difficult to put the brakes on an emotionally driven behavior. One survey found that people check their phones 144 times per day and at least half of investors check their investment performance once a day or more. This compulsive behavior can lead to something called “myopic loss aversion”, a greater fixation on losses over gains leading to ill-considered trading actions with negative long-term consequences. A willingness to be uncomfortable with current market conditions but still stay the course is habit worth developing.  

The flip side is panic buying. When the market, or a stock, is rising rapidly, investors fear missing out on further gains. They may dive in at any price without regard to the inherent risks. We tend to internalize trends. During a bear market, investors anticipate price contraction and in bull markets investors expect price expansion. This is the context in which we make decisions.  

It’s hard to overcome our basic hardwiring. The survival instincts of our ancestors were honed through millennia. Quick reactions to threats often meant the difference between life and death. When they observed others in their group panicking, it served as an alarm system, indicating immediate danger without requiring each individual to directly perceive the threat. Those more attuned to these cues were more likely to survive and pass on their genes. Today, we inherit these instincts. But in the context of modern financial markets, herd behavior is a risk, especially during extreme periods when prices are dislocated from intrinsic value. The tendency to panic when others do can lead to impulsive decisions, like selling off investments during market downturns. This illustrates a fascinating aspect of human evolution: traits that once ensured our ancestors’ survival can sometimes manifest as less beneficial behaviours in today’s vastly different environment. 

It’s tempting to emulate the investment choices of media pundits or social media influencers but remember that there are a lot of different ways to make money. Or lose it. Each of us has unique goals and tolerances to real or perceived risk. Investors must select a strategy that suits their temperament and one they can maintain regardless of short-term market gyrations. Your ideal risk tolerance is easy to figure out: Select investments that align with your financial priorities without losing sleep. If you lose sleep, it’s a clear sign you have taken on too much “risk”.  

Felix Narhi, Chief of Investment Officer and Portfolio Manager


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