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May-04-12

Does Risk Tolerance Change in Volatile Markets?

One of the most important aspects of our work with clients is to identify risk tolerance. We then use modern portfolio theory as a guide to a sensible asset allocation of risk appetite to various investments, and help to avoid risks that do not have a higher expected return. Sounds easy? Perhaps, until investor behaviour comes in to play.

The definition of risk tolerance, according to the International Organization for Standardization, is the extent to which the investor “. . . is willing to risk experiencing a less favourable financial outcome in the pursuit of more favourable financial outcome”. In other words, risk and return are related. How much downside can you live with in pursuit of a bigger upside?

A paper entitled Individual Financial Risk Tolerance and the Global Financial Crisis by Australian researchers Paul Gerrans, Robert Faff and Neil Hartnett, published in February 2012, looks at the question of whether risk tolerance changed as a result of the financial crisis in 2008/2009.

The study looked at data provided by over 3,000 investors in Australia/New Zealand, UK and North America who completed FinaMetrica’s Risk Tolerance questionnaire on at least two occasions between 2001 and 2009. The study found that there was no apparent change in risk tolerance as we went through the market gyrations of 2008 and 2009. This is certainly contrary to investor behaviour as we saw major moves from equity to fixed income markets through the period. Why?

Let’s assume our risk assessment results in a client being convinced that he could handle a downturn of 20%. If the markets are down by 15%, the investor may fall prey to recency bias – he extrapolates that 15% and perceives a higher loss is imminent which will push beyond the 20% comfort level. The decision is made to sell. Risk tolerance has not changed, but risk perception has. Our perception or expectations drive our behaviour, which in turn drives the return on our portfolio.

There is an increasing body of work in academia on behavioural finance, which is now reaching the mainstream. Our guest speaker on May 22 and 23, Carl Richards, has brought the topic to the public’s attention through his book “The Behaviour Gap: How to Stop doing Dumb Things with your Money”. His sketches bring clarity to some of the more complex concepts in the world of finance. Carl will speak in Toronto on the evening of May 22, Ottawa at noon on May 23 and Montreal in the evening of May 23. If anyone is interested in attending one of these sessions, send an email to malongi@pwlcapital.com.
 

By: Kathleen Clough | 0 comments