Over the holidays, I published my new book, Investment Illusions: 12 Common Illusions That Can Sabotage Your Financial Success.
Purpose of Book
This book was written for the individual investor, but will likely be purchased by financial advisors (in bulk) for their clients. I review 12 main illusions, which are fed by our behavioral biases. The book opens the investor’s eyes to how our brain works, is tricked by these financial illusions, and what they can do to improve their investment decision-making.
Similar to the way I speak and present, this book is concise and filled with information; there is no fluff. I try my best not to waste the reader’s time.
An Offer For You
I invite you to order and read the book. It is self-published through Amazon in both paperback and Kindle format. You can order it here. If you like the book and leave a 5-star review on Amazon prior to January 22, let me know and I will send you an Amazon Gift Card for your time and consideration.
If you want to order the paperback in bulk (at least 100), please contact me directly and I will provide a bulk order at a ~35% discount to the listed price on Amazon. NOTE: Members of The Behavioral Finance Network receive the book near cost.
An Excerpt From Chapter 7: The Illusion of Risk
THE RISK OF RISK PROFILE QUESTIONNAIRES
The purpose of risk questionnaires is to identify a proper allocation of securities given the investor’s risk preference. A typical risk profile assessment asks a series of multiple-choice questions about your time horizon, investment experience, and portfolio preferences. There might even be a few “what if” questions. Each response is given a corresponding score used to calculate your risk tolerance, and suggest an allocation of securities commensurate with that risk.
Risk profilers are not as robust as you would think, or hope. They suffer from two fatal assumptions: that the investor is rational (not true), and that risk is static (also not true).
Risk profilers see investors as how they should behave and do not account for how we really act. For example, the time horizon question will produce a high score (greater risk tolerance) if you say you won’t need your money for 20 years. The thinking is that a rational individual that doesn’t need their money for 20 years can handle significant fluctuation in account values – because their time horizon is so far in the future. This is the rationality assumption at work. But long-term investors, because they are human, are still influenced to act based on short-term outcomes. Have you ever found yourself worried about recent market losses even though you won’t need your money for many years?
A common risk profile question will show four portfolios, from conservative to aggressive. The conservative portfolio has a low annual rate of return, but experiences less fluctuations in returns from year to year. The most aggressive portfolio shows a high average rate of return with the potential for significant fluctuations along the way. Many investors will choose a portfolio with a higher rate of return, perhaps taking on more fluctuation than they can truly live with. While they recognize the portfolio can go down a lot, they aren’t feeling it at that moment. They aren’t experiencing the fear, anxiety, uncertainty, and stomach churning that accompany a down market. They aren’t thinking about how brutally hard it will be to hold on. This may cause investors to select a portfolio that they cannot psychologically handle.
For that same reason, “what if” questions may elicit misleading responses. What would you do if your investment portfolio went down 30%? Most people say that they will buy more or hold tight. Such response will recommend a greater risk profile, which may not be the right fit. This, in turn, means that when the next bear market comes, investors may experience more losses than they are comfortable with, and thanks to the influence of the amygdala, end up selling low.
Another flaw with risk questionnaires is that our risk tolerance is not static. Imagine taking a risk profile questionnaire when the market is down over 20%, companies are laying off employees, analysts are slashing estimates, and more losses are predicted in the future. In other words, imagine you are filling out a questionnaire when fear, anxiety, and hopelessness abound. Compare that to filling out a risk questionnaire after your account has gone up in value, analysts are talking about the strength of the bull market, and how much further it has to go.
It doesn’t take a genius to realize the responses would be very different. Our perception of risk is greatly influenced by our mood and emotions, which in turn is influenced by our physiology. Just like a corporate balance sheet, a risk tolerance questionnaire attempts to define your risk preference on a given day and is subject (and likely) to change as circumstances change.
That’s not to say risk tolerance questionnaires serve no purpose. They can help define a starting point to discuss risk with your advisor, but by no means should be viewed as a flawless tool that will correctly divine your risk. A comprehensive assessment of your risk tolerance and subsequent allocation should include several conversations about your financial and psychological ability to tolerate losses – given your past experiences, brain’s hardwiring, and financial constraints.
Psychologists have found that our true risk tolerance is significantly influenced by our early experiences with investing. Your past experiences will tell you more about your risk tolerance than any financial questionnaire. In fact, how you responded during prior market events is the single greatest predictor of how you will respond in similar future market events – regardless of what a risk profiler may say. Consider your past investment actions, and ask these questions…