As a supplement (or possibly in some more carefree circumstances, a substitute) to a psychometric assessment of risk tolerance, an adviser may sketch a chart like the one below and invite an investor to say which path they’d prefer to be on.
The way a chart like this is usually presented ensures everyone picks B and hey presto everyone is ‘medium risk’ (give or take a leaning towards A or C that define the upper and lower bounds of medium).
This has the advantage of matching what we know about risk tolerance – that it’s normally distributed, and heavily clustered either side of the middle. However, it has the disadvantage of being misleading. For A, B and C don’t show risk.
The focus of a chart such as this is on the journeys. But risk is not about the journey; it’s about where you could end up. What the chart shows is volatility. The difference is important and goes well beyond the world of semantics and theory. Misunderstanding the difference leads directly to mismanagement of risk in the real world of investors and their investments.
A better way of looking at it is something like the graph below, that shows ranges of possible outcomes for some typical portfolios (on some simple and reasonably conservative assumptions) over 10 years. Risk is the chance of ending up with an outcome on the low side of those distributionsregardless of how turbulent the journey that got you there.
For each level of risk, we can see (in blue) the distribution of possible outcomes after 10 years of investing, and (by the red dots) the expected returns of the bottom fifth, average, and top fifth of the expected outcomes. For example, 20% of the medium-risk portfolios had a return higher than 67%, while the most likely return is 40%.
Investment risk is the risk of money not being there when it’s needed, reflecting both the chance and the severity of poor returns. An investor’s risk tolerance is their willingness to accept the chance of bad final outcomes in the hope of good ones. Risk management is therefore investor-specific, because for an outcome to be bad, it needs to be badforsomeone.
Volatility, on the other hand, is the risk of a bad journey (towards a bador a goodoutcome). Willingness to accept volatility is therefore a different matter to risk tolerance, despite the proliferation of profiling tools that confound the two, that mistake comfort for success, that measure turbulence and call it risk.
If you look at a graph showing the history of an investment’s value over a given period, it will tell you how volatile that investment was over those years. It won’t tell you how risky a decision it was to purchase it at the start of the period, because the path it took was one of innumerable paths it could have taken. And yet many risk-tolerance assessments continue to ask about perception-based tendencies like optimism and pessimism in financial decision-making.
When adequately understood, it’s clear that while volatility is visible, risk is not. Because while you can see ups and downs along the way, and indeed where you ended up, you cannot see either the chance of ending up where you did, or all the other places you could have ended up, but didn’t.
This is important, because misunderstanding the difference leads to mismanagement, which in turn leads to more uncomfortable, and quite possibly poorer, clients. A meaningful understanding of risk is crucial for good financial decision-making.
Unbundling relationship management
A deeper understanding of what risk really is tells us not only a) how much long-term risk is right for each investor to take right now (in the context of their long-term plans), but also b) which elements of the experience of this risk over the journey should be accepted rather than avoided. In other words, it helps you know if an investment is suitable or not.
A suitable approach to investor management builds a solution for the right level of risk to take, based on the investor’s risk tolerance and risk capacity and – separately – puts in place a plan to control their emotional reactions to volatility, based on their financial personality – their preferred means of meeting emotional-comfort needs.
Taking the most volatile portfolios off the table does work, in one sense. But risk avoidance isn’t risk management, and forgoing the chance of higher returns is often an excessive price to pay for being more comfortable with short-term turbulence.
Ideally, we’d all avoid risk if it cost nothing to do so. But avoiding risk never costs nothing. It means giving up the chance of gains. We’re better off acknowledging the trade-off and managing not the volatility, but how it affects us. Why give up on a good destination when we could simply change how we’re likely to behave along the journey?
It’s not the size of the risk, but what you do with it that counts
Risk management is not about avoiding risk, it’s about getting the best deal for the risks you choose to accept. It’s not smart to pay with foregone returns for protection from volatility when it’s only the visibility of the volatility that affects your emotional comfort. Sometimes, shutting your eyes can open you up to otherwise overlooked opportunities.
The most successful outcomes – theanxiety-adjusted returnsthat account for both investment returns and the investor’s emotional comfort – are determined not by avoiding complexity, but by knowing how to navigate it.
For investors with very low composure, that are prone to panic-sell in response to any market dip (and especially for those investors that are also prone to track their portfolio more frequently, and therefore see more dips to panic about), limiting exposure to volatility might be a good means of managing their risks of poor ultimate returns. However, for many there is a better way. Taking risk without being emotionally derailed by volatility can be accomplished more cheaply for most by both preparing for, and reducing the visibility of, short term ups and downs. Why pay with lower expected returns what could be bought with tailored education, or changes to how financial information is presented, or well-timed reminders of the longer-term plan at the exact moments it’s threatened by short-term behavioural tendencies?
The key to coping with volatility is self-knowledge. Specifically, knowledge of the right level of risk to take long-term based on a dynamic risk profile, and the ways in which doing so could be uncomfortable in the short-term – and how best to mitigate them – based on a unique financial personality. It’s time to bring a bit more real-life behavioural psychology to the public’s real-life relationship with risk.