Balancing Risk

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					                             B A L A N C I N G R I SK
                                                                                                    In a world of unavoidable
                                                                                                risks, we each add our own,
                                                                                                often involving our finances.
                                                                                                Experts link our tolerance of
                                                                                                   risk to many factors, from
                                                                                                evolution to gender, to a lust
                                                                                                   for thrills, luck against the
                                                                                                   odds or anticipated regret
                                                                                                       over possible loss. Our
                                                                                                psychology, says one, makes
                                                                                                              us bad investors.
                                                                                                        But there are ways to
                                                                                                  overcome our blind spots         |
                                                                                                    B Y G A I L VA Z - O X L A D E

                                    Dr. Ena Garmaise and her husband, Gordon, measure
                               investor risk behaviour and manage investment portfolios

D O YO U O R D O N ’ T YO U ? If it works, you’ll be so far          anyway, since what’s risky for one of us may not seem the least
                                                                     bit dodgy for someone else. George Hartman, author of Risk is
ahead. On the other hand, if it doesn’t … well, “toast” would
                                                                     a Four Letter Word (Stoddart), defines “risk” as the potential for
be the word, wouldn’t it? Do you dare? Against what odds?            loss: “It could be loss of capital, it could be loss of purchasing
                                                                     power or the loss of sleep.” He also says, “It’s kind of macho at a
Other people always seem so much bolder—or more
                                                                     cocktail party to stand up and say, ‘I’m a high risk-taker.’”
timid—in similar situations. How do you balance the upside
against the down? Would you risk a wipeout for even a little         Gender factor
edge, or does it take a $10-million jackpot before you’ll chance     MACHO? WE LL, AT LEAST PART OF RISK TOLERANCE
a buck? One thing market meltdowns tell us, implicitly, is that      is in our genes, or so it would seem from the research done by the
a lot of people must be pretty cavalier about their nest eggs, or    new kids on the block, the experts who study behavioural finance.
they wouldn’t have laid them so far out on such slender limbs.       Women are less tolerant of risk than men. It’s true. But before you
Investment risk and its natural counterpart, diversification,        go getting your topknot in a twist, this isn’t gender bias. And it
may be standard terms in the financial lexicon, but as investors     isn’t all bad news. I’m a woman (check the byline) and I have no
we often clearly resist heeding the high-risk warning, watching      trouble accepting the possibility that women, by their nature,
the safety demonstration about diversification or recognizing        may be less risk-tolerant. But don’t take my word for it.
the signs of a wild ride ahead.                                          In his book Galen’s Prophesy, Jerome Kagan cites epidemio-
    What is it about our species that makes us willing to assume     logical surveys indicating a greater female susceptibility to the
a little risk or a lot? And how exactly does one define that word    state of fear. (Kagan, who teaches psychology at Harvard, stud-

Returns           ARE YOU A RISK-TAKER?

 ied the cognitive and emotional develop-        mists like to talk about the risk/return          “People who are very afraid think they are
 ment of children in the first decade of         relationship.”                                    taking more risk than they actually are.”
 life, focusing on the origins of tempera-           That’s supported by other findings            According to most personal finance
 ment.) He suggests that man’s socializa-        that have come to light through the               authorities, what most of us need as
 tion as a hunter and his need to face fear      research of Terrance Odean, assistant             investors is a scorecard to match our risk
 regularly has biologically reduced his          professor in the Graduate School of               profile, uncovered through clever ques-
 negative reaction to fear. Primitive            Management at the University of                   tioning, against a portfolio that perfectly
 women, socialized as gatherers, had less        California, Davis. Odean describes the            matches our risk tolerance.
 exposure to the fear factor and so con-         difference in male and female investment             That leaves out all those superficial
 tinue to react more strongly to fear. The       patterns this way: Men churn, women               six-question risk profiles that quickly
 result: Girls are, at every age, more fearful   earn. Odean, who has conducted detailed           and without much thought rank us as
 than boys. According to Kagan’s studies,        studies of investors’ trading patterns,           high-, medium- or low-risk investors. Six
 “among the distressed infants who               suggests that men’s overconfidence in             questions aren’t enough to create a clear
 showed high fear at both 14 and 21              their investment skills leads to underper-        measure of how brave or timid we are. To
 months, 86 per cent were girls.” Note           forming portfolios.                               be able to stay the course with an invest-
 those ages. These are toddlers who have             Gordon Garmaise sees the phenome-             ment plan, investors need to have confi-
 yet to suffer the vagaries of modern-day        non only slightly differently: “Whether           dence in the risk-profiling exercise.
 socialization. That fear factor is bred in.     men are more foolhardy or not, they are
     Dr. Ena Garmaise agrees. She and her        almost always incurring market ineffi-            Recency is hard-wired
 husband, Gordon, own Garmaise                   ciency by trading too much. Trading is            AC C O R D I N G TO E NA GA R MA I S E ,
 Investment Technologies Inc., a $2.6 bil-       one of the most certain ways to generate          people are hard-wired to overreact to
 lion investment counselling and portfo-         negative return increments.”                      recent events. “This works if you’re a for-
 lio-management company. They also cre-                                                            ager. If you’re looking for food, the best
 ated the Client Investor Profile, a risk            Risk and perception                           place to look is where an animal was yes-
 analysis questionnaire used by Mac-             T H E N T H E R E ’ S O U R A B I L I T Y TO      terday.” So recent events are good predic-
 kenzie Financial Corp. for both its Star        delude ourselves into thinking we have            tors of what will happen today.
 and Keystone clients. While she’s the           a risk profile that’s higher than it really is,      “Often when people are successful, that
 behaviourist, he’s the financial whiz, and      or, conversely, to underestimate our              increases their tolerance for risk,” she adds.
 together they make for an interesting           capacity for risk-taking because we’ve            “Having won big, they consider themselves
 perspective on risk.                            always thought of ourselves as chicken.           now to be playing with ‘the house’s
     In her analysis of risk profiles from all   “People are often perverse,” Ena                  money.’”
 over Canada, Ena Garmaise sees distinc-         Garmaise says, and she tells about a                 Again, Hartman agrees: “A lot of peo-
 tive differences between men’s and wom-         tightrope walker that some psycholo-              ple have accumulated wealth in the past
 en’s desire to take chances. She has col-       gists interviewed to learn how he han-            few years rather easily,” he says. “They
 lated     thousands        of     completed     dled risk. “I don’t take risks,” the man          didn’t have to be shrewd about it. They
 questionnaires and analyzed them down           insisted. “Everything I do is very con-           basically just had to show up. So people
 to the most minuscule detail. One of her        trolled, and I know what I’m doing.”              perceived there was very little risk in it.”
 most interesting findings is something              “From our point of view,” says Dr.               Market movements also push risk-tak-
 most people filling out the question-           Garmaise, “he isn’t correct. He hasn’t            ing beyond our natural inclination. No
 naires probably never consider: The cor-        perceived properly the risk that he’s tak-        matter how much the experts talk about
 relation of the use of the titles Mr., Mrs.,    ing. By any objective standard, he’s taking       market cycles, investors cling to the
 Ms., etc., to response patterns.                a lot of risk.”                                   idea—ill-formed—that wherever we are
 “Uniformly, at every age,” says Dr.                 Hartman cites a similar parallel, liken-      today in the markets, that’s where we’ll
 Garmaise, “those who use ‘Mrs.’ are less        ing people who leap into roller-coaster           stay. So if we’re in a rising market, it will
 risk-taking.” (Women who use “Ms.” are          stocks to those who jump off tall towers          continue to soar, while a sudden down-
 closer to “Mr.” but there’s still a differ-     with large elastic bands tied to their feet.      turn in the cycle can make us run,
 ence. “Dr.” comes close to “Mr.”, too,          “It’s a little experiential,” says Hartman.       screaming, for the exits.
 regardless of gender.) “When I mention              So it would appear that some people              According to Gordon Garmaise,
 this to some people, it really raises hack-     take risks because they don’t understand          “People buy funds that earn 50, 60 or 70
 les,” Garmaise says. “But even though it        that they are taking them. Or perhaps the         per cent returns up to the point at which
 may be true that men are willing to             fact that they face extreme risk over and         they buy them and imagine that they
 take more risk, it doesn’t mean that men        over is the reason they develop a higher          have found a secret formula that pro-
 are doing better, because it doesn’t mean       tolerance, almost a numbness to risk. The         duces returns at no or limited risk. What
 they’re taking ‘efficient’ risk—as econo-       opposite is also true. Says Dr. Garmaise:         they don’t realize is that by buying a high-
SIX WAYS TO CUT RISK                                ket’s shenanigans. But there are always          could come, and you would regret not
                                                    investors out there who are unwilling to         having waited.” According to Dembo, the
  A mix of investments reduces risk
                                                    settle for good enough. They want spec-          big question is: “Which outcome will
  because when one type isn’t doing well,
                                                    tacular. “It goes against the psychological      cause the least regret?” Once you figure
  another should pull the portfolio along.
                                                    grain,” says Ena Garmaise, referring to          that out, you know what path to take.
  “Asset mix,” “investment mix” or “asset
                                                    going long on investments. “People                   Dembo puts a great deal of emphasis
  allocation,” it’s all the same thing. Effective
                                                    believe that if they work very hard at           on the emotional side of risk as mea-
  diversification means not only buying
                                                    studying companies and mutual funds, at          sured by the amount of regret a decision
  assets of different kinds (equities, bonds,
                                                    looking at screens and looking at data,          might cause. But risk isn’t simply an
  etc.) but also mixing things up within each
                                                    they’re going to do better than average.         emotional issue. If it were, as investors
  kind—equities in different companies,
                                                    It’s a fundamental human condition.”             we would be left to the vagaries of our
  which are also in different industries and
                                                        The reason, she suggests, is that peo-       emotions, without giving any weight to
  possibly different countries.
                                                    ple don’t like the idea that there’s ran-        the roles our intellect, experience and
     Six ways to diversify:
                                                    domness in their lives. They are deter-          wisdom play in helping us better under-
  I by investment type—bonds, deposits,
                                                    mined to maintain their illusion of              stand why we take the risks we do.
  stocks, mutual funds, real estate
                                                    control. “[People] want to believe that              Take, for example, the scenario many
  I by investment quality—the lower the
                                                    the things happening around them are to          investors faced watching stocks like
  quality, the higher the return offered, to off-
                                                    some degree influenceable by [the] appli-        Nortel or Bre-X rise dramatically. Their
  set the higher potential for loss
                                                    cation of rationality,” Gordon Garmaise          realized regret at not having participated
  I by region—Canada, North America, the
                                                    interjects. “And it just isn’t the case in the   in the glory and riches of these stocks out-
                                                    stock market. But it is an illusion that is      weighed any potential regret they might
  I by currency
                                                    very hard to give up.”                           experience in terms of the risk to their
  I by liquidity—some long-term deposits,
                                                        Nobody ever suggested that investing         capital. Behavioural finance has for a long
  such as stripped bonds or equity funds,
                                                    off our gut is a sensible thing to do. So        time held the idea that an actual loss hurts
  along with shorter-term investments
                                                    why do investors keep doing it? “There’s         more than an opportunity loss. But what if
  (Treasury bills)
                                                    another inclination that has also been           the actual loss is in recognition (for being
  I by manager style, when the portfolio
                                                    documented,” says Dr. Garmaise, “and it          smart), in connectedness (belonging to
  holds mainly mutual funds
                                                    is that some people like a long shot. It         the “in” groups of investors playing) or ego
                                                    makes life more exciting.”                       (see, I am smart!) and the potential loss is
                                                        Adds her husband: “If you have a crav-       our sweat-stained money? Then regret
performing fund they are guaranteeing               ing for an extremely large return, even          could work against us, while the intelligent
themselves a very risky investment.”                though it has a very low probability of          application of a sound risk profile might
   If those in the know had their way,              occurring, you’ll overweight its impor-          keep us on the straight and narrow.
we’d all dollar-cost average ourselves into         tance and take the risk.”                            “I’ve been very surprised at the people
a pool of investments that closely                                                                   who have told me they bought Nortel on
matched our tolerance for risk while pro-           Risk and regret                                  the way down,” says Gordon Germaise,
viding a healthy, if often unspectacular,           D R . R O N S . D E M B O , PR E S I DE N T      who suggests that “anchoring” may be
rate of return. We’d all be tortoises.              and C.E.O. of Algorithmics Inc., a               one explanation for a leap into a declin-
                                                    provider of innovative enterprise-wide           ing stock. “People saw the stock had been
Optimist’s illusion                                 financial risk-management software, and          at $20 or $30 before; it went to $120, and
O P T I M I SM PL AYS A B I G PA RT I N             co-author of Seeing Tomorrow: Weighing           they were anchored in this range. So the
how invincible investors feel. “Two finance         Financial Risk in Everyday Life, believes        middle of the range seems like quite a
professors have done research to show               that regret is the appropriate measure           reasonable place to be.” Once the stock
that price movements on stock markets               against which to weigh risk. “Risk is rela-      passed the midpoint on its way down,
are considerably greater on sunny days,             tive, which is one reason why it’s so hard       investors decided that Nortel was a good
and that’s blowing people minds,” says              to quantify,” he says. “Volatility doesn’t       buy. The question now, of course, is this:
Dr. Garmaise.                                       really capture it.” Dembo uses the exam-         Is $65 a ridiculous overvaluation of
   Her husband is more categorical.                 ple of a man who’s retiring and wants to         Nortel or is the stock not, in fact, ridicu-
“There is no predictability for the factors         sell his house. “Along comes someone             lously undervalued now? Only time will
that are going to influence the market,”            who says, ‘take it or leave it, but tell me in   answer that one.
he says. This, of course, is why the pun-           a day.’ It’s a low offer, but if you turn it         Understanding risk does not necessari-
dits all take the position that you must be         down and can’t sell, you’ll really regret it.    ly mean investors have to give up all the fun
a long-term investor because that’s the             However, there is also the possibility that      of playing the market. “As long as you are
only way you can ever cope with the mar-            tomorrow another, much higher offer              not gambling a significant part of your
holdings, then it’s great,” says Ena            produced rates of return appropriate to          fine, as long as they understand the risk
Garmaise. Assigning no more than five to        the level of risk he or she is taking over       they are taking.” However, disappointment
eight per cent of our portfolios to active,     longish periods of time.” That means mea-        awaits those who refuse to accept that risk
speculative investments would not only          suring your fund, or any prospective             is involved, who don’t look at the downside
provide the thrills most of us are seeking as   investment, against appropriate bench-           before making the decision to jump in.
investors, it would distract us from the vig-   marks. In the case of mutual funds, it               Even when a stock or fund seems to
ilant watchfulness over the rest of our port-   means looking at year-over-year returns          have a successful medium-term run, with
folios, which could then grow in peace.         over five or more years to identify volatili-    three or four years of heady growth, that
                                                ty, and comparing apples with apples             doesn’t mean all’s well. In fact, just the
Far, flat horizons                              when it comes to portfolio makeup, style         opposite may be true. “Economists look-
W H I L E E C O N OM I S T S L O O K VE RY      and geographical orientation. “You want          ing at that pattern look at mean rever-
far into the future and the past, investors     to see how you should have expected to           sion,” says Ena Garmaise, referring to the
have a hard time doing either, suggests         do with the information you had at the           idea that the price of an investment will
Ena Garmaise. “We have very high per-           beginning of the [investment] period.”           fall to where it should have been, “while
sonal discounting. If something is doing            But no one cares about diversification       an investor looking at the same pattern
very badly now, and it’s going to do very       and asset allocation as risk-management          sees a predictor of future growth.”
badly for the next two years, let’s get out.”   strategies when one sector of the market is          The most difficult part of dealing with
We end up making decisions on a short-          taking off at 60 per cent-plus returns.          risk may be coming to terms with our ten-
and medium-term basis, instead of using         During the last bull market, says Hartman,       dency to work against our own best inter-
a long-term investment horizon. “Our            “People thought they were being penalized        ests. Whether through overconfidence,
psychology makes it very hard for us to         by following good investment advice.”            optimism or machismo, we’re very happy
be good investors,” Dr. Garmaise adds.              The concept of diversification has been      to work extra hard to lose more money. If,
“Because we overreact to recent events,         around for a long time, perhaps so long          instead, we took the long-term view, laid a
we narrow our investment horizon.” The          that we’re unwilling to stick with such an       plan and stayed the course, remained true
answer, then, is to match one’s invest-         “old-fashioned” idea. After all, if diversifi-   to our risk profiles, we could be wealthy
ment risk profile to a well-diversified and     cation is the answer to risk, one has to         with a lot less effort. Maybe we need to
efficient portfolio and forget about it.        wonder why people don’t just do it. “Some        give diversification a catchy new name, to
    “Don’t abandon your oversight respon-       people don’t want to hear it,” says Gordon       make it a little sexier. Then, perhaps, we’d
sibilities,” says Gordon Garmaise. “You         Garmaise. “People want to have fun. They         heed good advice and take only the risks
need to make sure that your manager has         want to go for the long shots. And that’s        for which we were most prepared. ^
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                                                                                                 NOVEMBER/DECEMBER 2001
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