The floor of the New York Stock Exchange.
(photo credit: REUTERS)
Financial advisers spend a lot of time trying to understand a client’s risk profile. They often employ questionnaires that ask a myriad of questions to try and pinpoint the time period of an investment, investment knowledge and how one would react in various market scenarios. The problem with these questionnaires is that they only paint a picture based on current trends.
What do I mean by current trends? In a recent interview with the Motley Fool, Israeli Nobel laureate Daniel Kahneman explained this concept.
“The decision-making process is basically inferring from recent trends as if they were to continue,” he said. “That seems to be the information that people go on, and so when things have been getting worse for a while, you become pessimistic, and when things have been getting better for a while, you become optimistic, and it’s those feelings that really control the investment, I think.”Confidence
When I was a struggling new oleh, cleaning toilets to pay the rent, I needed to purchase an airline ticket to fly back to the US. I was a big fan of trading options – an aggressive investment approach – and had some success, so I said I would trade options for a short period of time and make enough money to purchase a ticket and then some. Lo and behold I succeeded, and I was off to the US. Then I got overconfident and started trading options a furious clip, and within two weeks I was once again a struggling oleh cleaning toilets! My own overconfidence led me to dismiss various risks and created a sense of stock-trading invincibility. Ric Ferri, an author, columnist and pioneer in low-cost index investing, compared the risks of fighter pilots with the stock market.
“The same feeling occurs with investors who experience a large loss in their wealth or experience an easy profit,” he wrote. “We become overly concerned about our future after a bad financial loss and become overconfident after easy profits.
In reality, the risk of loss is always present. It’s only our perception of it that changes.”Skewed perception
It’s our short-term memory that skews our perception. My hunch is that if you give an investor a risk-profile questionnaire to fill out in the midst of a bull market and then give another one during or after a market fall, you will end up getting different responses.
I recently opened an account for a client who insisted that he was a long-term investor. He was a big believer in emerging markets and decided to put all his money in exchange traded funds (ETFs) that track various geographical regions in Asia and Latin America.
About six weeks into his investment he called with a panicked tone. He said he wanted to sell out of his investments because they had dropped 6 percent on average. I reminded him of his insistence six weeks earlier that he was a long-term investor. He said the drop scared him and he believed the market is going to crash, and he wanted only the most conservative investment.
It’s not just my client. Many investors have a large appetite for risk when things are going well. When markets aren’t so kind, they are the first to run for the exits.What should you do?
As I have written many times, investors should focus on achieving their goals, not trying to make as much money as possible in the market. Money should be used for specific purposes, not to die with the most amount of money possible. The one who dies with the most money does NOT win! Take out a pen and paper and prioritize your short- and longterm goals and needs. Then create a portfolio that will enable you to achieve what is truly important to you.The information contained in this article reflects the opinion of the author and not necessarily the opinion of Portfolio Resources Group, Inc., or its affiliates.[email protected] Aaron Katsman is a licensed financial professional in Israel and the United States who helps people with US investment accounts. He is the author of the book Retirement GPS: How to Navigate Your Way to A Secure Financial Future with Global Investing.