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- IE:MONEY NOVEMBER | DECEMBER 2001 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- world 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. ^ COPYRIGHT IE:MONEY MAGAZINE NOVEMBER/DECEMBER 2001 REPRINTED WITH PERMISSION.