What’s Your Investment Risk Appetite? And how it results in poorer investment decisions
What’s your investment risk appetite, or risk tolerance for investments? Virtually every wealth manager or financial advisor now has to determine their investment client’s risk appetite or risk tolerance prior to recommending investments to them. In theory, this is so that investors with low appetite or tolerance for risk should not be recommended investments which are not suitable for them. But can the opposite be true? That the process of determining an investor’s risk appetite understates their risk appetite and results in them taking on too little risk, and leaving their future at risk instead?
An investor’s risk appetite or risk tolerance is usually defined as a measure of how much of a loss an investor is willing to endure within their investment portfolio. It should take into account the investor’s age, investment goals, income, and comfort level, and this is subsequently matched with the volatility or price risk of the investments which the advisor may recommend to them. In general, going through this process would avoid an investor with a lower risk appetite ending up with 100% invested in equities, and one with a higher risk appetite from having too much invested in government bonds.
While that may the case in theory, in practice, many investors come to their advisors with an investment in mind already, and hence the risk appetite determination process is simply matching their answers to the questionnaire to end up with a high enough recorded risk appetite to justify their investment. Or, in the extreme case, an advisor may even “guide” the investor into answering the questionnaire in such a way so as to justify the investment they are selling to them! These cases aside, does the risk appetite really help investors in making better investment decisions? Or does in result in poorer investment decisions?
Do investors with high or low risk appetite make better or worse investment decisions?
Why is your investment risk appetite important?
Understanding risk appetite or risk tolerance is an important component in investing. The ability and willingness to withstand large swings in the value of the investments made is critical in being able to weather the downturns that will inevitably occur over the investing horizon. Conversely, the inability or unwillingness to bear such investment losses can mean that the investor is likely to panic and sell the investments at the worst possible time.
As a result, an investor with a high risk appetite or tolerance, and is financially literate will be able to invest in higher risk investments such as equities and Exchange Traded Funds, and so maximise their returns over time by taking on more risk. An investor with a moderate risk appetite or tolerance may opt instead for a mix of stocks and bonds, and hence accept moderate returns for a moderate level of risk. A conservative investor with a low risk appetite or tolerance will invest more heavily in bonds, for a lower, but less risky, rate of return.
What’s wrong with risk appetite?
So what is wrong with determining your investment risk appetite? The approach outlined above clearly makes sense, especially for an institutional investor. As a rule, institutional investors have pretty simple objectives – maximise profits for the risk taken. So the risk appetite determination and the subsequent investments made make a lot of sense. But individuals have a more complex set of objectives, and hence it is not easy to carry over something that is fit for purpose from the corporate or institutional world, into the personal finance world.
Let’s take a look at some instances where the investment risk appetite determined can lead us astray when investing:
1. Multiple objectives and time horizons for investing
For example, an individual investor can be investing for both the long term (e.g. retirement), the medium term (e.g. children’s college tuition), and the short term (e.g. deposit for a property). Clearly, the risk appetite for each of these different objectives can differ, because of the length of the investment horizon. This is something which needs to be taken into account in theory, but in most cases, the risk appetite is focused on the tolerance of losses, without a clear distinction between the horizon. And this is something which can lead us to making poorer investment decisions.
Now, anyone who has studied finance will know that a common assumption which is used to describe financial prices and investment values is that they follow a random walk with a drift or trend. The drift or trend is basically the underlying expected returns to the investment, while the random walk nature, or the zig-zag pattern of prices through time is the volatility or risk of the investment. This is not a 100% accurate assumption, but it does work surprisingly well in most cases. This also means that the expected returns will scale (almost linearly) with time. However, the volatility or risk will scale with the square root of time. Which also means that what seems to be a high-risk investment over a short period of time, will be lower in risk (relative to return) over a longer period of time.
Let’s look at a simple example: Suppose there are two investments, with the following characteristics:
Higher risk and Lower risk Investments
|Higher Risk Investment||Lower Risk Investment|
|Average 1 year return||7.0%||4.0%|
|Average 1 year volatility||15%||7.5%|
|Risk Free Rate||1.0%||1.0%|
|Long Run Compound Return||5.875%||3.719%|
|Sharpe Ratio (1 year)||0.40||0.40|
|Sharpe ratio (Long Run)||0.325||0.363|
This is a made up example, so do not try to look for investments with these exact characteristics! Although the higher risk investment does look a lot like investing in stocks right now. We calculate the long run compound return by adjusting the average 1 year return for the effects of volatility over time, as we show here. The Sharpe Ratio is a measure of the risk-reward trade-off, with a higher Sharpe ratio being better. In this example, the lower risk investment actually has a better Sharpe ratio than the higher risk one!
In the typical way the risk appetite assessment is done, the investor is asked about the tolerance for losses. For the higher risk investment, a 15% annual volatility will translate into 30% losses with a 5 chance every year. For the lower risk investment, the 7.5% annual volatility will translate into a 15% loss 5% of the time annually. So naturally, it will look like the higher risk investment is truly higher in risk!
But that is true only in the short term (or over a year). As returns scale linearly, while risk scales with the square root of time, over time, returns will surpass the risk. As we see below, in the case of the higher risk investment, this cross-over point happens around 5 years later:
Risk versus Return for the Higher Risk Investment over time
In the case of the lower risk investment, this cross-over point occurs some 3.5 years down the road. So what may seem like a vast difference in risk between the two investments over a short period of time (1 year), virtually disappears when we look at it over the medium to long term.
Risk versus Return for the Lower Risk Investment over time
But look at the vertical axis, which is at the same scale for the two charts. In the medium term, the risk-return of the investments of apparently higher and lower risk virtually disappears, but the returns will have a wider and wider gaps between them. Hence, someone who has a lower risk appetite, and chooses to invest in lower risk investments for the longer term will end up having a greater chance of missing their wealth accumulation targets! And if we are talking about investing for retirement, the risk of missing the target level of wealth for investment may actually be the greater risk the investor is taking!
2. Loss aversion distorting our perspective on risk
A second major flaw in determining risk appetite or tolerance is that the questionnaires are almost invariably focus on losses. This is where our loss aversion gets the better of us. Loss aversion (also here) is a term coined by Nobel Prize winner Daniel Kahnemen and his long time (but sadly, late) collaborator Amos Tversky in their groundbreaking research on human behaviour and behavioural economics and finance. Simply put, people in general prefer to avoid losses rather than acquire the equivalent gains. And this distorts how we think of losses and risk appetite.
An example of this is the choice between these two outcomes:
- Only spend 80% of what we spend now
- Lose 20% of your disposable salary
Now, these two choices are, in fact, exactly the same outcome, only expressed differently. But time and again, experiments have shown that people tend to to choose choice 1 over choice 2. Why? Because the mention of “loss” makes us more averse to that choice, even if it describes exactly the same thing.
And this brings us back to our investment risk appetite. The process of determining the risk appetite or tolerance more often than not focuses on the tolerance for losses. Given what we know now about loss aversion, it makes us appear more conservative and having lower tolerance for risk than we truly are, simply because of the way the questions are structured. While entire businesses and industries have been deliberately built up to exploit various aspects of behavioural finance, the financial advisory industry seems to have been “accidentally” built up to exploit this instead!
Why our investment risk appetite hurts our investing decisions
All this, especially the theoretical mumbo-jumbo, would be mildly diverting if they did not have critical consequences for us investors. Let’s illustrate this with an example. Going back to our higher and lower risk investments above, suppose they are marketed to two salarymen. The first with higher, and the other with lower risk appetite, as determined by their financial advisors. Other than that, they are identical in every way:
Your typical salarymen
|Initial Salary||$36,000 per year|
|Salary Growth (Annual)||3% per year|
|Final Salary at Retirement||$76,376 per year|
|Initial Savings Rate||25%|
|Savings Rate Growth (Annual)||1%|
|Final Savings Rate at Retirement||50%|
|Final Spending before Retirement||$37,000 per year|
Now, for our two friends to have an equivalent lifestyle in retirement, assuming that the 4 percent rule works, they would need to have accumulated $961,000 after 25 years of savings and investment. If one of them invested in the higher risk investment, and the other in the lower risk investment, how will they fare by retirement? Remember, after 5 years, the risk-reward tradeoff from these 2 investments look very similar, and neither one can be considered higher or lower risk than the other.
25 years of Saving and Investing
In the chart above, our hero with the higher risk appetite just about meets his/her retirement savings accumulation objective. Even with the yearly volatility of higher risk investments, the final outcome ranges between 77% and 121% of the target. So all is good for retirement. Our hero with the lower risk appetite ends up with only 80% of the target retirement savings accumulation objective. And the volatility of this investment would result in a range of 66% to 90% of the target.
Is this shortfall in retirement savings acceptable? It may be, if you think of it as the choice 1:
- Only spend 80% of what we spend now (pre-retirement)
- Lose 20% of your retirement savings
But it is actually equivalent to choice 2, losing 20% of the retirement savings! And this is likely to be a risk that most of us are unwilling to take. Yet, by our acceptance of our risk appetite earlier on (25 years earlier, to be exact), we may end up making a poor investment decision for retirement, taking on a risk far greater than the yearly fluctuations in our investment portfolio value. It is far greater, because at the point of retirement, there is no turning back. Committing to live on less in retirement is the same as losing an equivalent amount in investments, whether we think of it that way or not!
So think carefully about your real risk appetite or tolerance when you start making investments for retirement today. Virtually everyone has a pretty low risk appetite or tolerance when it comes to having enough for retirement. This in turn means that your risk appetite for short term investment losses must be high today. So don’t be misled by loss aversion or whatever method of determining your investment risk appetite into taking on an even larger risk, from which there is no way to return.
If your risk appetite for having sufficient for your future retirement is low, your tolerance for investment risk must be high today!
And that, perhaps is the beauty of mandatory retirement savings, like the CPF. CPF is arguably the most successful form of saving and investing for retirement we have. And yet the CPF Board does not bother to ask you what your risk appetite is! They just garnish your monthly salary into the three CPF accounts, pay you interest on each of them, and finally make sure you put them into CPF LIFE and MediShield Life! And yet it works!
Virtually every fiduciary principle and regulatory rule requires wealth managers and financial advisors to determine their client’s risk appetite or risk tolerance before a recommendation is made to them for an investment. But is this process actually helpful? As we show, in many important cases, this may end up in the investor making poorer investment decisions. Personal financial management is more complex than corporate or Institutional financial management, because our personal lives are multi-faceted, and may have many conflicting objectives to be met in a finite lifespan. Which is why adopting concepts directly from the world of corporate finance to personal financial management may not always be appropriate.
Clearly, determining risk appetite through a process which emphasises loss primarily plays right into the psychology of loss aversion. Which means that for most part, we can end up making poorer investment decisions. Unless, we recognise this, and the other factors which are just as important as loss tolerance in making investments decisions based on our goals. We deserve better than the usual unthinking processes served up by our financial institutions and advisors, all in the name of ensuring compliance with fiduciary principles and regulatory rules!