Monday, May 26, 2008

Risk Appetite - Objective or Subjective

An interesting thought which came up the other day as I was travelling in the bus was one of exploring and understanding the concept of risk appetite, and what it actually meant for investors. One should understand that the concept of "risk" as we know it (and which is defined by fund managers and academics) is that of the volatility of an investment or asset class. Thus, the premise which is built upon this foundational concept will necessarily revolve around minimizing volatility within one's portfolio in order to "minimize risk". As I will be discussing in the paragraphs below, this is a flawed concept which may result in substantial losses for the average retail investor.

I think most readers would have experienced some form of "risk appetite assessment" at some point in their lives; whether it is during the financial evaluation being performed by a financial planner or perhaps an indepedent financial assessment being conducted by a fund manager to ascertain one's risk tolerance. In such cases, the term "propensity for risk" comes into play; and this essentially attempts to quantify and measure a person's tolerance for risk and for risky activities (a score or weight is attached to each response in a typical questionnaire). The term risky activities will relate to the asset class one wishes to invest in, as well as the returns reasonably expected from the person in relation to his return on investment (example, if you expect +/- 20% then you are considered "aggressive" and therefore likely to be able to take on more "risk"). Such questionnaire are inaccurate in at least 2 ways that I can think of:-

1) Each person's propensity for risk is a function of his own personality AND the current state of the economy and market. It is important to note that during the boom days, risk was defined as "not making more than your neighbour by day-trading stocks", while at the nadir of the market in 2003 risk was re-defined as "trying to prevent losing your pants due to the relentless fall in the stock market". The point I am trying to get across is that risk depends on how an individual feels about the health of the economy and the state of the stock market; and this is communicated through media reports and news articles. Right now, news reports mention manufacturing output dropping to its lowest level since 1983, and inflation hitting a 26-year high of 7.5% in April 2008. Thus, investors would probably be more risk-averse as they feel that the economy is teetering on the brink of recession, and it would be foolhardy to put money into equities when there is a chance of more downside. During boom times, irrational exuberance creeps in and causes one to take on more risk for the simple purpose of trying to beat the guy next door. Thus, I argue that one's propensity for risk is a subjective measure, not an objective one which can be measured using a questionnaire.

2) "Risk" as defined by value investors is the danger of losing your original capital, and I did mention in a previous post that capital preservation is a central tenet in investing. Thus, the proper and correct way to assess risk propensity would be to ask questions relating to preserving one's capital, and not base it upon the volatility of a particular portfolio. If one invests properly and with a margin of safety, then there is very little risk of losing money; volatility will NOT affect the returns from an investment if the underlying company's business is stable and growing. Academics get it all wrong when they equate volatility with risk.

Risky behaviour is basically investing in things we do not understand or have limited information about. In fact, when I casually survey my friends about their investments, a large number have not mch idea on the company they had bought, thus bringing me to the conclusion that they have engaged in risky behaviour. In such cases however, people may already be aware that they are speculating, but still insist on it for reasons other than rationality (something like playing the lottery when the chances of winning are amazingly remote!). So, I will leave this topic as part of my behavioural finance series under "Gambler's Fallacy".


la papillion said...

Hi mw,

I'll leave a comment before I sleep :)

I was filling this survey to find out my risk for investment and I tell the person that risk is subjective and contingent. It depends a lot on the situation that one is facing and the circumstances leading up to the situation. I thus told the person that I can't ans a lot of the questions, haha :)

I agree totally that risk comes about when one do not know what one is doing.

Btw, I'm classified as a highly aggressive (and thus risky) investor. Oh well :)

Derek said...

Hi MW,

I totally agree that risk is subjective which makes it very difficult for one to define.

If one was to tell his agent that he is a low risk taker and his agent recommend him some Unit Trusts as compared to someone who buys a particular stock only after extensive research. Who is taking a higher risk? On one end, the low risk taker is taking a high risk by not knowing what he is investing in but yet the unit trust in itself will be relatively safe. On the other hand, the stock owner though feels confident on his stock after extensive research but yet stocks itself is very volatile.


Alisa said...

Risk means different things to different people. To some, it may mean nothing, to some it may mean everything, and to others it may mean something today and something totally different tomorrow.

The saying "Know Thyself" must surely apply to the investor! For when it comes to risk the investor must know what their portfolio can tolerate as well as what their nerves can tolerate.

And yet, in the short time I have been on my investment journey I am learning that there are so many variables that can come into play!

Must one know and understand them all in order to guard against them?

I look forward to following your Behavioural Finance Series.

Be well.

musicwhiz said...

Hi LP,

Oh well, they classify you that way but it may not be the case; it's all very subjective. In fact, even your mood that day may influence the way you answer the questions ! Haha.


musicwhiz said...

Hi Derek,

I think in your example, the investor will not be knowing exactly which companies the fund will invest in; thus implying loss of control. However, if the investor willingly delegates the task of investing to someone else and lets them assume risk, then he is in effect transferring his risk to someone else.

When investing directly in equities, one must do enough research as one has no opportunity to delegate the risk to someone else !


musicwhiz said...

Hi Alisa,

Thanks for visiting my blog and for leaving a comment.

Yep, you are right in that there are many factors contributing to risk and there are many variables involved. The human mind and stock market are complex adaptive systems with a learning mechanism as well; thus it is highly unpredictable (though people constantly try !).

I would say it is close to impossible to know all the factors which come into play in order to make a 100% informed decision. We can only make decisions based on all available information at any one point in time; which leaves some aspects still uncertain. But this is the nature of investing - if everything were crystal clear then the market would be 100% efficient, a notion I do NOT subscribe to.

I will continue my Behavioural Finance Series in due time. Currently, I have a lot of results of my companies to analyze.


Ginger Cat said...

There are two elements of risk - severity and probability. Severity is the impact of the adverse event happening (lives lost, financial damage), while probability is the likelihood of that event happening. So in risk management we should allocate resources to those risks that are highly probable and highly severe. Then graduate downwards to the least probable and least severe.

An example to illustrate is if I locked my key in my house. I can climb through an open window to get it. Assuming the climb is not physically challenging and the window is waist high, the risk is low. Now imagine if this window is on the 20th floor and while there is good footing available outside the window, the same act will have a very different risk. While the probability of falling down is very low (assume good footing), the severity is catastrophic. So I will probably avoid it.

Similarly for stocks and finance. Something that may happen rarely, but can wipe you out... you should take measures to hedge against. This is the concept of insurance. Things that are very probable but low in severity we should not waste resources insuring (like theft of my 50c ballpoint pen).

musicwhiz said...

Hi ginger cat,

A very nicely-put analogy, thanks ! You segregate risk into severity and probability. In the market, I would say probability is easier to compute, while severity relies more on the fundamentals of the company (e.g. most penny stocks have poor fundamentals and may cause more severe losses). But the 2 are inextricably tied too with regards to companies as there is a high probability of severe loss if one invests in a lousy company with poor management. I wonder if we can really separate the two ? Hmm....

Insurance should be taken only on worthwhile things, I agree. This is why companies insure their stock, fixed assets and their personnel.