Big Risk Energy
Key Takeaways
Majority of people are often concerned with the risk-levels of their investment portfolio, but the truth is one of the biggest factors of risk lies within the decisions made by the investor.
The ongoing equity bull market can lead people to wrongly assume that making money from stocks is very easy. Leading them to discard simple but time-tested methodologies of reducing investment risk such as diversification.
If you are considering a new investment strategy, ask yourself:
Does the investment make sense?
How does it fit into your life?
How has it performed during downturns?
What’s the likelihood of losses? Can it be quantified?
Risk is about how we make decisions, and only incidentally about the math that we employ to reach those decisions.
— Peter Bernstein
When we speak to investors and clients, a common question that always pops up is about what risks do their investment portfolio face. However, behavioural scientist Dr Meir Statman jokingly notes that that the biggest risks in life are not in the stock market. If you want real risk, he tells people to get married. And if you want even more risk, have children.
People laugh because the point is obvious but not immediately apparent. The more people you need to care for, the more pertinent your need to meet current and future financial obligations, and your ability to absorb financial setbacks to keep driving toward financial goals, such as adequate retirement income.
Apart from financial obligations, studies on human behaviour and biases frequently point to overconfidence as a significant cognitive bias and as a result, a significant risk. We broadly tend to be over-optimistic about our abilities and life prospects, which feeds into how we make decisions.
Psychologists Don Moore and Paul Healy highlight three types of confidence shortcuts and overconfidence errors in their paper The Trouble with Overconfidence. Overconfidence includes over-placement (over-estimation of one’s rank in a group of peers) and over-precision (over-estimation of the accuracy of one’s beliefs).
These errors tend to appear more often in tasks which are deemed to be easy or when results have previously come easily.
For example, driving is relatively easy, prompting many people to overestimate their driving skills. A frequently cited study done in 1981 reported that 93% of American drivers commit overplacement errors, ranking themselves, on average, as above-average drivers. A diagram from the study (shown below) shows that the bulk of the respondents rated themselves much safer and more skillful than their peers.
Overplacement in investing is dangerous. Various commercials for a brokerage firm that specialises in foreign exchange trading end off with the phrase:
It’s your world. Trade it at Forex.com.
The adverts suggest that it is relatively easy to make money from trading and presumably, is suitable for everyone as the overconfident people depicted in the commercials. One can even say that the advert was engineered to boost your confidence, so you engage on their platform. Yet how many traders in the forex markets do you know that have long-term gains? The road is practically littered with the shattered dreams of many hopeful investors.
The ongoing equity bull market can create overconfidence — especially for investors who had placed all their faith in the technology sector. Tech stocks like Nvidia have been on a tear this year, and the easy success and high-flying returns can lead people to wrongly assume that making money from stocks, or choosing that winning stock, is very easy.
Overconfidence could also lead investors to discard simple but time-tested methodologies of reducing investment risk such as diversification or even seeking a second opinion from a fiduciary advisor on whether their portfolio is properly constructed and on the right track.
As we approach the seasonally weak period for markets (see diagram below), keep the following in mind.
If you are considering a new investment strategy or are thinking of tweaking your present one;
Does the investment make sense? — in terms of economic value, future cash flows, and profitability?
Does it fit into what you intend to do and what are the significant changes from what you were doing before?
What is the record of this investment during market turmoil and downturns?
Can the manager quantify the likelihood of losses of this new strategy?
Sitting back and taking time to consider some of these points may help to temper some of the overconfidence that we feel when thinking of making a switch.
Often, speaking to an advisor to ask for a second opinion can also help in ascertaining whether you are heading in the right direction.
If you are interested in seasonal weakness, and election year tendencies for stock markets, come and chat with us.
