Redefining Risk: Unrealistic Expectations To Blame For Sentiment Shift

There’s nothing like a bear market to turn otherwise aggressive investors into risk averters. But that’s just what’s happened. People who were once comfortable with a healthy stock component in their portfolios are now seeing their tolerance for risk wear very thin. Many are throwing in the towel – but at what may prove to be the very worst time.

Risk attitudes

After giving this topic a bit of thought, I concluded that investors’ collective tolerance for risk hasn’t changed one bit. Rather, investors held unrealistic expectations about the level of achievable returns and the true level of risk exposure they were assuming in seeking this return potential.

Of those who had some of their portfolios in stocks a couple of years ago, nothing could have changed so much since then to cause people to want little to no exposure in stocks. But that’s exactly what’s happening with many investors.

I contend that investors simply weren’t fully educated on the true short-term risk of investing in stocks and the benefits of proper diversification. It’s not for lack of trying. Investors diligently read articles on sites just like this one; grabbed monthly mutual fund reports religiously; and sought the services of financial advisors.

So, why did investors end up still underestimating stock market risk?

One possible reason is that investors became blinded by stellar returns posted by stocks and, as a result, gave little credence to the possibility of a 1973/74 style bear market – which is exactly what we’ve got in terms of the size of the market decline.

Another possible explanation are the droves of financial advisors that subscribe to the “100 per cent stock” doctrine. Some popular industry speakers have been vocal advocates of all-stock strategies for many years. Of course, they always endorsed diversifying within the stock component, but they assigned little importance to fixed income classes because – as the argument goes – stocks perform best over the long term so why bother owning anything else.

This reasoning simply fails to recognize the impact that volatility (i.e. up and down price swings) can have on investor behaviour and – most importantly – on “investor” returns. It further ignores the fact that stocks can underperform bonds for several years at a time before showing superior longer-term returns.

In truth, not all investors will have a homogeneous definition of risk. Some might define risk as the chance of outliving their portfolio (i.e. failing to meet their stated objectives); others as suffering a permanent impairment of value; yet others might simply consider risk to be nothing more than the frequency and magnitude of declines in value.

Suitability and working with an advisor

Arguably, assessing an investor’s true tolerance for risk is an investment advisor’s most difficult job. While a good advisor will design a client’s investment strategy based on return expectations, time horizon, and other constraints; an investor’s tolerance for risk is one of the more important variables in designing customized strategies. This is so because an individual’s portfolio has to fit in two ways:

– The portfolio must adhere to the goals, expectations, and constraints of the individual.

– The portfolio must sit comfortably with its owner through a full cycle.

The latter point is at the heart of what I’m seeing today from many frightened investors; which is why financial advisors must go far beyond the mandatory “Know Your Client” form (KYC for short) to get a good feel for each client’s true comfort level.

Past behaviour

Historically, mutual fund investors tend to follow performance. Ironically, where fund investors tend to invest their money is usually a good contrarian indicator – i.e. where not to go. Here are just two of the many examples history has to offer.

I studied monthly data from the Investment Funds Institute of Canada (IFIC) ranging from November 1993 through July 2002. Only four times have investors pulled money out of pure stock funds (on a net basis) – January 1995, September 2001, June and July 2002. The latter three months listed remain fresh in our minds, but January 1995 followed a year that saw rates rise at an extraordinary pace – which is bad for both bonds and stocks. But this was short lived, as rates began dropping quickly in 1995, thereby propping up both bond and stock prices – which attracted strong flows of cash from mutual fund investors.

The most striking symptom of investor behaviour in recent memory fell smack in the middle of the technology boom. Then, investors shunned today’s most popular fund group (the “slow-and-steady” Dividend Income class of funds) for a full 18 months – from the end of March 1999 through the end of September 2000. The worst part is that these conservative funds weren’t just ignored – nearly $2 billion (about 8.5 per cent of assets) was yanked out of these funds during that period. Over the past year, however, they’ve been one of the best-selling classes of funds.

This behaviour is a problem because investors move in reaction to recent events, rather than moving in anticipation of them. It’s not that investors should market time, but successful stock market investing (whether through funds or stocks) requires the confidence to buy early and the patience to wait until your expectations are realized.

However, most investors don’t do that – which ultimately results in investors realizing a rate of return that is below their expectations.

Recommendation

While occasional steep declines in stock prices are a reality, the challenge for scared investors is to understand that this won’t go on forever. Buying tech stocks at the height of the euphoria was a silly idea. Along the same line of thinking, swearing off stock investments forever is a bad move right now. Ultimately, investors must answer this question:

Did you own stocks two or three years ago because it was the best way to achieve your long-term investment goals; or was it simply a way of making a quick buck? Your answer will go a long way toward assessing whether your investment decisions today are governed by emotions or by fundamental needs.