Investor Risk Tolerance Changes Are Counterproductive

June 10, 2014
Laura Joszt

Investors' risk tolerance decreased as the stock market faltered during the recession, which is counterproductive if investors want to maximize returns.

Investors’ risk tolerance decreased as the stock market faltered during the recession, which is counterproductive, according to a study in the Journal of Financial Planning.

Michael Guillemete, assistant professor of personal financial planning in the University of Missouri College of Human Environmental Sciences, and colleagues analyzed investors’ willingness to take risks during a unique time period when equities experiences large swings in valuation.

“At its face, it seems fairly obvious that investors would be less risk tolerant when the stock market is underperforming,” Guillemette said in a statement. “However, this may lead to investors buying when the stock market is high and selling when the market is low. If an investor is only buying when the stock market is up, they are limiting potential returns they could earn from their investments.”

The researchers used average monthly risk tolerance scores (MRTS) from January 2007 to May 2012 provided by FinaMetrica, surveyed 341,782 individuals on risk tolerance during the time period, and factored in investor sentiment. When consumer sentiment was most negative, survey respondents were most risk averse.

“Also, we found that while risk tolerance followed trends in the stock market, risk tolerance didn’t change as much as the stock market,” Guillemette said. “So when the stock market dropped by about 50% during the recent global financial crisis, risk tolerance dropped by about 7%. What this tells us is that risk tolerance is very dependent on the traits and personalities of each independent investor.”

Investors are most risk averse when equity valuations are low, and therefore most attractive to purchase. Although risk tolerance scores are closely correlated with the S&P 500 when the stock market is falling, Guillemete and colleagues found that this isn’t the case when the market is on an upswing. While some see a risking market as a buying opportunity, others remain risk averse after recent losses, the researchers surmised.

“Investors should only purchase stocks for long-term goals like retirement funding,” Guillemette said. “Television networks like CNBC and the Fox Business Network sell the misperception that those short-term fluctuations in stock prices matter. However, investors will be much better off if they focus on long-term, rather than short-term returns.”