How should we Think About Risk?

/risk/ - possibility or chance of loss. exposure to danger.

Risk is often viewed as a negative concept, but should it be? Risk by its very definition implies uncertainty and can therefore be unsettling. However, risk is a central element to any professional portfolio and it’s construction strategy; as it must be managed and navigated to generate a real return (reward). In broad, general terms, risk and reward tend to be positively correlated. The traditional thinking is the more risk one assumes the more return they would be likely to receive than if they had not taken any risk. Now, this is not always true and taking on more risk can merely mean a wider range of outcomes, not necessarily better rewards. However taking no risk at all will rarely ever produce an acceptable reward. What are we to do? How should an investor think about risk? In this two-part article we’ll address how, risk as a basic concept, features in developing a portfolio. We’ll also review interesting studies about this concept and attempt to recognize our subconscious biases when considering risk.

Start with transparency and an honest assessment of a situation. Properly evaluated and intelligently managed risk can lead to sufficient rewards. Still our perception of risk will evolve over time relative to what we can afford to lose and is therefore not a static metric. Making intelligent decisions upfront can go a long way to having more flexibility down the line however. Sooner or later when things get difficult in the capital markets, an investor’s true capacity for risk emerges. Being proactive to ensure portfolio risk aligns with your tolerance and return demands, may save headaches later on.

At Hudson Oak Wealth Advisory we have established procedures, assessments and tools to help clients articulate their tolerance for, and understanding of, risk as well as our ability to evaluate their attitudes on the topic. Risk is a foundational concept to a well-designed investment portfolio. Once this capacity for risk has been appropriately assessed and examined the next steps of portfolio management may properly occur. Time and again however, we find that most investors preach a certain sentiment towards risk at the outset, but practice a different approach altogether once reality comes into play. It’s easy for most to state, “I don’t mind risk and understand some basic investing concepts” until their portfolio declines 20% over a short time and they are confronted with assessing the validity of their prior statement. Some Americans do not even invest, and many of those that do invest don’t understand the risk they are currently taking in their investment portfolios compared to the appropriate level of risk required to fulfill their needs. The investment risk can be either too high or too low for each investor’s needs, but due to the level of uncertainty involved many investors rarely feel comfortable with the unknown.

50/50 - a study

A classic example of risk assessment and how determining risk capacity is easier said than done, was demonstrated by economist Daniel Ellsberg. Follow along with Ellsberg’s thought experiment and see how you fare yourself to better understand how you might assess risk.

Imagine 100 balls are placed inside a solid container, half are red, the other half are black. You make a choice (which is recorded but not revealed to others) as to which color ball you guess will be randomly drawn from the container. If you are correct you receive $10,000. If you are not correct, you win nothing. Ellsberg then stipulates you are only allowed to play once. If this is the case, which color do you choose and what is the maximum you would pay to play? MIT professor Andrew Lo polls his MBA students on this scenario and recorded his finding in his book, Adaptive Markets. Many of his students wager up to slightly less than $5,000. This natural occurrence makes sense as $5,000 is the expected value of the game’s worth considering you either win $10,000 or win nothing. The market of participants self-regulates to reach this expected value.

However, what if the same game exists but you don’t know the proportions of the 100 balls? There could be 100 of one color or 100 of another and anywhere in between - you just know that they are either red or they are black. When Lo asked his students what is the maximum bet they would make in this instance, only a few bids take place at all and very few meet or exceed $4,500. The reason students give for not placing a bet is because of their uncertainty (risk) and discomfort to not knowing the odds. Lo states that this shows his students (and most people in general therefore) are willing to take risk, but only when they have certainty as to the risks - which is an inherent contradiction. If you look up the definition of risk, risk and uncertainty are often viewed as interwoven concepts. In reality, it isn’t this simple.

Now, honestly ask yourself, how would you behave in this scenario? The two situations have the exact same odds of selecting the ball of your chosen color or not - 50/50. In one case you have the certainty of knowing an equal distribution of red and black, while in the second example the same two options are available and a random unknown distribution should yield the same odds - but the unknown causes us to lose comfort. This thought experiment articulates very well that thinking and feeling are very different when real risk is involved (see: money). You can know the two games have the same odds, but your emotions can dictate behavior when the risk feels more or less certain.

Famed experimental psychologist Daniel Kahneman determined that when people were faced with uncertain outcomes they exhibited biases. One of the most common biases for investors being loss aversion. This means that even despite statistical evidence to the contrary, when faced with risky outcomes we place greater weight on avoiding losses than achieving gains. This is because when money is involved we don’t think in terms of odds and probability as clearly. We succumb to behavioral and emotional biases and think of money in terms of certainty, security and utility to us. We like to avoid risk which is part of our natural survival instincts and psychology as human beings for thousands of years. Humans apply these same habits to investing even when evidence suggests otherwise at times.

Next week, in our second article of this two-part series, we’ll give a whole new meaning to the term March Madness and discuss another key factor that inhibits many investors from overcoming their fears to think rationally about risk. If you have questions concerning portfolio risk please seek the guidance of a qualified financial professional.

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