Jul 14, 2008
“Everything’s Fine ……Until It’s Not”
This piece is another in a series that takes a closer look at how investors typically make investment decisions. In this case, we look at one of the key inputs in developing an investment strategy – risk tolerance. An investor’s tolerance of risk is an individual and personal assessment. Research suggests, however, that few of us understand ourselves as well as we think, and our ability to project how we might react in certain situations is surprisingly inaccurate.
Risk tolerance is often described in general terms as conservative or aggressive or as an expression of preference between growth and capital preservation. Attempts to quantify risk tolerance with more precision often involve questionnaires that ask investors how they would react to certain situations.
The limitations of these approaches are newly addressed in an entertaining book, Predictably Irrational, by Dan Ariely, the Alfred P. Sloan Professor of Behavioral Economics at MIT’s Sloan School of Management. Ariely’s research of human behavior concludes that when someone is in a stable (cool) state, their predictions of how they will behave in an unstable (hot) state will usually be wrong. The effect of emotion or passion is systematically underestimated in how it can control our behavior.
Ariely conducted numerous experiments on MIT students where the students were asked to predict how they would respond to questions under conditions of stress and arousal. In all cases, the student’s behavior under these simulated environments differed dramatically from how they responded when asked under a controlled environment. Ariely acknowledged he had proven something that car salesmen and auctioneers have known for years – logic and rational behavior is easily compromised during times of emotion and passion. (He suggests never making a car buying decision right after a test drive, especially if you are shopping for a family car and were enticed to test drive a Porsche).
The relevance of these findings is particularly compelling to investors. Relating this phenomenon to risk tolerance, investors typically assess their capacity to incur short-term losses in a controlled state. When in the midst of a nasty sell-off, however, these risk parameters often succumb to the emotion of the moment. It is one thing to answer a questionnaire about reacting to a 15% loss, but when in the midst of losing 15%, the focus is just as likely to shift to fears of losing another 15%.
Ariely’s tests show that even if we understand this behavior in advance, we have a hard time protecting ourselves from these feelings. He suggests the best way to keep from making harmful decisions during anxious moments is detachment, or avoiding the opportunity to become anxious (i.e., not opening statements or watching CNBC).
While abstinence from the nightly dose of Jim Cramer’s Mad Money is not a supreme sacrifice, the “head-in-the-sand” solution to short-term volatility is probably not a realistic option for most investors. On-going communication with a professional investment manager is clearly designed to help temper these feelings, but what we can all learn from Ariely’s insight is knowing that there are two distinct sides to ourselves. The “cool thinking” side works fine in most environments, but a sell-off environment is not the best time to make the acquaintance of our alter ego.