Risk exists in every single aspect of our lives. Yet, it cannot be easily expressed because it means different things to different people.
That is why, when evaluating what the risk of a particular asset allocation or an investment product is, you must view in a very specific context and how it fits in with your life and personality.
I list down three stories that will drive home my point.
It is not just experience that matters, but the relevant experience.
I can never forget the narration of Jason Apollo Voss, chief executive officer of the US-based firm Deception And Truth Analysis Inc.
Years ago, his daughter went on a week-long river rafting and camping trip. This was the scheduled annual trip organized by her school, so it was not exceptional. However, the previous winter had especially heavy snow fall and so the river was exceptionally high, and with fast rapids. Worse, the weather for that week predicted heavy snowfall and freezing temperatures.
On the very first day, the rafts capsized in the river. The students were in danger of suffering from hypothermia. Most of the food and medical supplies were lost to the river. Yet, the instructor in charge refused to return and decided to persevere through the rest of the week. Consequently, several students had to be hospitalized.
When the parents demanded an explanation, the school authorities informed them that their instructor is extremely experienced and led these expeditions for over a decade without incident.
What was wrong?
The school administration engaged in an incorrect risk analysis of the instructor’s experience. The relevant experience for the situation was not how many years of expeditions he had led (wrong context). The relevant experience for the situation was how many expeditions he had led where everything went wrong, and from the very beginning (correct context). It turned out that the instructor had never really come anywhere close to experiencing these difficulties in the past.
Financial Implication: This is why investors prefer experienced financial advisors who have gone through various bull and bear markets. They understand what is risk and how to navigate turbulent market upheavals.
Do read What is Risk?
What’s risky for you, may not be risky for me.
Kat Cole is the chief operating officer of food company Focus Brands.
When she was at university, she worked as a waitress at an American restaurant chain. She excelled and was named best employee. They requested her to go to Australia to train employees at a new franchise. At that time, she was not in possession of a passport and had never stepped on a plane before. She grabbed the opportunity.
Her studies began to get severely affected. She had no powerful and connected friends. Nor did she have an affluent family to fall back on. In her world, college was the surest path to success and stability. So when she decided that she would drop out of college for the job, it appeared like a very risky call that could backfire with disastrous results.
The gamble paid off. She was offered a salaried job at the corporate headquarters and became an executive vice-president by the time she was 26. At the age of 32, she was hired by Cinnabon (of Focus Brands).
Many would consider dropping out of college to be risky. This is why context is important. Kat’s father was an alcoholic and her mother had to work multiple jobs just to make ends meet. From the age of nine, Kat had to help with the house and look after her two younger sisters. Now she was getting the opportunity to travel abroad. She was excelling and being appreciated for a job she loved. She was achieving the security and stability she lacked as a child. She was being presented with a way to get what she ultimately wanted, even if it was not on the terms most people would be comfortable with. It seemed a better option to stick on and work her way to an executive job rather than accumulate college debt.
For many, dropping out of college is risky. But here the alternative was very compelling.
Financial Implication: This is why you should not copy someone else’s portfolio. For example, a particular investor may do well to have a credit fund in his portfolio. But it could be a bad choice for an investor who cannot afford to lose any money.
I wrote about this in more detail in How to put the odds in your favour.
What you magnify, you obsess over.
On March 8, 2014, Malaysia Airlines Flight 370, carrying 227 passengers and 12 crew members, lost contact with air traffic control less than an hour after taking off from Kuala Lumpur. It veered off course and disappeared.
A plane crash is sensational. But the macabre nature of this incident lay in the fact that it did not crash, but vanished into the night. Think about it. In today’s digital age, we can contact anyone, anywhere, anytime. In fact, to be disconnected, even for a short while, requires a conscious decision and a fair bit of planning. So an aircraft going "off the radar" was extremely bizarre. The entire world was gripped with this story.
An article in the U.S. media noted that many more individuals died from heart diseases, strokes, cancer, car accidents and murder. But they did not garner as much attention as Flight 370. They did not get remotely as much news coverage.
Threats like plane crashes, which are statistically insignificant and not frequent, grab our attention and scare us more than those that are deadly serious but common.
When 9/11 was still fresh in people’s memories, more Americans avoided planes and preferred driving. Though, the latter is much more dangerous. The memory of the recent catastrophe made the fear of flying weigh more heavily than it rationally should have done.
This is the Recency Bias at play. And we look at certain things as risky, when they are not.
Financial Implication: When the market crashes, we immediately want to pull out of equity. A company’s bad quarterly earnings and we want to sell the stock. Something is always going on when it comes to geo-politics. All these are out of our control. Yet, we habitually ignore the slow-burning risks where we do exert influence: how much we save versus spend, how we have allocated your portfolio, whether we've built an Emergency Fund, and so on.
I wrote about this in more detail in Are you focusing on the wrong risk?
Risk is a strange beast.
- Risk is very personality driven. Some people are wired to seek out risk, be it in the markets or by jumping out of an airplane. Serial entrepreneurs may be more comfortable with risk than salaried individuals.
- Risk taking ability does not manifest in every aspect of our personality. A person who goes sky diving and bungee jumping may be very cautious when it comes to his money.
- An individual’s tolerance for risk may change with age. A younger person may be more open to risk than one on the verge of retirement. Conversely, the reverse also holds. She probably would have been risk averse when she was young and struggled to make ends meet. But is more open to risk once she found herself saving substantial amounts every month.
- Past experiences can have an influence on how an investor perceives risk. People who have lost vast sums in the market in the past may be uneasy about taking risk in the future.
More on Behavioural Finance
More by Investment Specialist and Senior Editor Larissa Fernand
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