Risk and Investing: A Behavioural Perspective

The biggest risk of all is not achieving what's important to you. It might be well and good that you can hold the portfolio because it doesn't breach your risk metrics. For example, you're comfortable with the volatility because it doesn't move around as much. But if that means you don't have enough money at the end, well, it's been a failure.

Risk is not volatility. Volatility is what the world of academia has used as a proxy for risk, but it is not risk. Risk is multifaceted. Risk is the potential for drawdown, which I think is really relevant. Volatility is a measure of risk because if people see things moving around all over the place, they might freak out. But risk is really about whether you’re going to achieve your goals long-term.

Being risk-averse is a risk in itself. So often, with loss aversion, people are worried about losing money. They're so focused on that they don’t consider the other risks involved. One of those risks might be running out of money. Part of that could be because inflation is eroding the value of their capital base. They don't understand that the risk of not taking enough growth exposure in their portfolio is, in itself, a risk, one that could prevent them from getting the returns they need to live the lifestyle they want or to leave the financial legacy they wish to leave.

I feel like the way risk profile questionnaires are positioned almost boxes people into saying they don't want to lose money. But at the same time, they're looking to achieve returns that are not consistent with being conservative. That’s where you’ve got to have discussions that go beyond the risk profile.

Another issue with risk profiling is that it doesn’t consider the time horizon. How long is this strategy going to be in place? Do you require liquidity? How will that impact the appropriate risk profile? Risk profiling only focuses on tolerance, it’s a single measure of client risk tolerance. What it completely ignores is the behavioural component that goes along with it. It ignores the client’s understanding of why they earn that money in that place for that period of time.

What is truly relevant is whether they are going to achieve their goals. That’s the most important component, and risk tolerance alone doesn’t cover that.

The perception of taking risks and getting longer-term returns is always underestimated. Whenever we speak to clients, we go through the initial discussions to see their expectations around investment returns and losses. Generally, they never match.

You go through a risk profile, and it will come out that the client is balanced. You put them in a balanced portfolio, but their risk tolerance is relatively fixed. It might change over decades, but it’s relatively fixed. Instead of placing them in a portfolio designed to meet that level of risk and maximize returns, they’re often put into an asset allocation portfolio that, over 25 years, works out on average. Then, the advisor has to spend one in every seven to ten years holding the client's hand, saying, "Don't sell out. Don't sell at the bottom. Don't worry, the risk will be fine."

It’s crucial that advisors don’t just focus on goals. Too much risk profiling is about financial goals, lifestyle goals, and personal goals. But you need to dig deeper into values. Values are the reason those goals are important. It’s about asking, “Why is that goal important to you?” instead of just putting it on paper and building a financial plan around it.

You truly understand a client’s risk tolerance in the real world when the markets are tanking. That’s when the rubber meets the road. That’s why you need to have multiple conversations and examples to refer back to at those moments. By the time you see the event unfold, it’s usually too late to take action. That’s generally not the time you want to bail on the strategy. However, only when negative events play out when markets fall do you truly see how people behave and what their real risk tolerance is.

If you follow FOMO behaviour on the way up and panic on the way down, it’s incredibly value-destructive. That’s the behavioural gap. The behavioural gap is when people buy at the top and sell at the bottom. There’s only one rule of thumb in investing that works, buy low, sell high. Science is about understanding what is high and what is low.

And that’s what we do. That’s what Innova does.

Credit to Innova for inviting Steps Financial to be a guest on this video.