How much risk are you willing to take in your investments? Financial advisers spend a lot of time trying to understand a client’s risk profile. Many use questionnaires which ask a myriad of questions that try and pinpoint the time period of an investment, investment knowledge as well as 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? A few years ago in an 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. 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.”
The last seven months have really highlighted this principle. Back in March when the market was getting crushed losing more than 30% of its value in five weeks, clients were gun-shy and wanted to lower their risk levels. Now, after the market has surged and made back all of the corona caused losses clients are requested higher stock market exposure.
As I have mentioned previously, back when I was a struggling oleh hadash (new immigrant), 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 that 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 2 weeks I was once again a struggling Oleh cleaning toilets!
I felt invincible and that overconfidence led me to dismiss various risks, and ultimately led me back to the poorhouse. Ric Ferri compares 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. 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.”
Is perception reality?
It’s our short-term memory which 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.
In August I opened an account for a client, who insisted that he was a long-term investor. He was a big believer in technology and decided to put all his money in both Exchange Traded Funds (ETFs) that track technology as well as some well-known individual stocks. About two weeks into his investment, he called with a panicked tone. He said he wants to sell out of his investments because they had dropped 8 % on average. I reminded him of his insistence just two weeks earlier that he was a long-term investor. He said that the drop scared him and he believes that the market is going to crash, and wants only the most conservative investment. True that in September the market dropped, but again it’s made up those losses. He called me a few days ago and asked if he should invest in tech stocks?
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 to 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 long-term 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.
Aaron Katsman is the author of Retirement GPS: How to Navigate Your Way to A Secure Financial Future with Global Investing. www.aaronkatsman.com