While everyone's risk tolerance level is unique, it turns out individual investors typically view asset riskiness very differently than financial professionals.
While everyone has their own tolerance for investment risk, it turns out individual investors typically view asset riskiness very differently than financial professionals.
The different ways individuals and professionals view risk can have very real consequences for portfolios, according to Nellie Oster, PhD, director and investment strategist in BlackRock’s Multi-Asset Strategies Group. In a recent post on BlackRock’s blog, Oster highlighted 3 ways these 2 groups differ in their risk thinking.
The financial industry focuses on an asset’s return volatility and correlation with other assets when measuring risk.
An asset with more stable returns is less risky than one whose returns are volatile. Professionals also determine how correlated an asset’s returns are to the returns of the rest of the portfolio. Through diversification, it’s preferred that an asset has a low correlation and does not move in tandem with other assets.
In comparison, individual investors are loss averse and generally measure risk as dollar loss. Typically, they focus on the price at which a security was bought.
“In other words, risk for them tends to only encompass downside risk, and it’s measured in dollar, rather than percentage terms,” Oster wrote.
She added that individual investors tend to focus on individual returns over a short period rather relating it to the overall portfolio. As a result, they underestimate the risk of assets the move with the total portfolio, and overestimate the risk of those that actual benefit the portfolio by providing diversification.
Attitude to risk
Environmental and demographic considerations heavily influence an individual investor’s attitude toward risk.
“Modern finance theory usually starts with the assumption that investors’ risk preferences are relatively stable,” Oster explained. “In reality, however, researchers have found that individuals’ attitudes toward risk vary considerably with environmental and demographic considerations.”
The source of risk is important. For instance, inflation doesn’t seem risky to individuals, and so they don’t change the sum invested. However, source of funds also affects attitude toward risk. Money won is more likely to be invested in risky assets.
Another aspect that can affect risk attitudes is how an opportunity is framed, according to Oster. People are more willing to gamble to avoid losses, but more risk averse when achieving gains.
Unfortunately, letting these factors determine risk can be dangerous as they can result in portfolios that do not fit with the individual investor.
Expectations about risk
Individuals are sensitive to past experience, so someone who has experienced low returns is likely to be more pessimistic. Millennials are currently risk averse and tend to avoid the stock market because they recently went through the financial crisis, which was likely their first experience with the market.
Professionals usually estimate an asset’s riskiness by using past volatilities and correlations, while individuals simply let past losses deter them.
“Rather than estimate future returns and volatilities, an investor may focus on the negative emotions of disappointment and regret that the purchase is likely to prompt in him, and he may distance himself from these emotions by avoiding that security,” Oster wrote.
Fix the affect of these differences
Oster recommended mitigating the differences the negative impact these differences can have on portfolios by working backwards from longer-term investment goals. After all, portfolio risk levels should also reflect targeted outcomes.
With a long timeline, a lower starting point, and a higher desired outcome, an investor should take on more risk. However, someone starting with more money and less of a distance to go should invest more conservatively.
“So, rather than first focus on one’s current feelings about risk, investors should instead focus on how to achieve longer-term goals using diversified portfolio allocations,” she concluded.