Financial risk is associated with the permanent loss of money. In order to measure the amount of risk a client is dealing with, advisors use maximum drawdown to measure the largest single drop from peak to bottom in the value of a portfolio. It also helps to offer financial advisors a worst-case scenario so they can prepare portfolios based on potential risks that are assessed.
To adequately prepare for maximum drawdowns and elevated risk, financial advisors spend a great deal of time educating clients on loss aversion and how it can affect client behavior. Loss aversion, first demonstrated by Amos Tversky and Daniel Kahneman, refers to a client’s tendency to strongly prefer avoiding losses versus their desire to acquire gains.
Most studies suggest that losses are twice as psychologically powerful as gains. There are four primary benefits of understanding loss aversion when helping clients cope with risk:
- Investments and stock shares can be sold quickly in times of decline
- Documenting past losses can help prepare individuals for future risks
- Remedies, including diversification, focusing on the big picture, paying less attention to accounts and the stock market can be applied to help save high-risk investments
Applying Mental Accounting to Regulate Investments
To avoid losses from occurring due to an investor panicking and selling at an inopportune time, certain strategies should be practiced by the advisor and client alike. Mental accounting helps individuals to organize, evaluate, and keep track of financial activities, including the source of the money and purpose for each account.
Because clients often value various amounts of money in different ways, mental accounting can help assign different functions to each asset group, which affects consumption decisions and other behaviors pertaining to investment strategies.
Unfortunately, bad things do happen to good people. When it comes to managing risk, we see many of these instances occur as a result of poor research and a constant desire to believe only half of the facts. Quite often, clients choose to ignore the base rate, also known as the base rate fallacy. This occurs when individuals are uncertain of the probability that something detrimental may occur and therefore follow historical probabilities from the past year in order to keep a low insurance deductible. Advisors will frequently encourage clients to ignore the basic, nonexclusive data and only focus on specific information that pertains to a certain investment decision unique to their particular portfolio.
Another way that clients often find themselves actually welcoming risk into their investments is through heavily practicing confirmation bias, which is the act of seeking out things that support your viewpoint, while ignoring data that disputes their belief. This bias may result in unforeseen risks and loss of principal.
Overconfidence in the investment process can also lead to serious declines and an elevated level of risk as it gives clients the assumption that their investments will be protected, despite the actual unpredictability of the stock market. This prompts frequent decisions being made without sound research and potential losses being overlooked.
You Win Some, You Lose Some – Why Risk is Needed
While playing it safe can seem like a good idea in the investment world, taking too little risk can actually cause problems to your portfolio. Taking a minimal approach to risk can result in investment loss when inflation is low, much like it is now, as no money can be made when it is sitting idle in a bank account. As an investor, keeping up with inflation is crucial, as the value of the dollar continues to drop. For example, 20 years ago, a Big Mac sandwich from McDonalds could be purchased for $1. Fast forward to today, where the same sandwich now is averaging $4.64. By applying an appropriate amount of risk to your investments, each dollar is able to stretch further as you continue to keep pace with the rate of inflation.
Regardless of the amount of risk you are willing to take, it’s important to diversify your investments. Rather than concentrating all of your risk in one particular investment, seek to hold multiple investments that all pose a different risk profile. By owning a series of investments, you can reduce the overall risk found in each individual investment. One may zig while the other zags, working together to reduce your risk.
For more information on risk management and how to accurately balance your portfolio, contact us today.