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.
In the spirit of this column’s focus on broadening our conventional thinking, we draw upon the wisdom of turkeys and the existence of swans, specifically black swans. What this has to do with the capital markets is detailed in the thought-provoking financial bestseller, The Black Swan – The Impact of the Highly Improbable, by Nassim Nicholas Taleb.
In our initial “Worth Mentioning” note last quarter, we wrote that the intent of this correspondence is to address a single investment topic from a fresh perspective. As topics go, the headline above would seem a little ambitious for this format, but we’ll use this as a brief introduction to the compelling principles of Behavioral Finance.
Most investors are familiar with the claim “It’s different this time” - a siren’s song, often heard right before the inevitable collapse of whatever was supposed to be different. We heard it in spades with the dotcom craze. At its essence, it is a rationalization for chasing performance (against one’s better judgment) and is usually all you need to hear before knowing you need to go the other way – fast.