Money Matters: Are you risk-averse or loss-averse?

By William Dostman III

The Daily Record Newswire

When investors discuss their portfolio, their first comment is almost always about return. While return is clearly important to every investor, the risk that is being taken to achieve that return is too often overlooked.

Nearly everyone believes that they are a rational investor. That is, they believe they're taking all of the information available and looking for the highest possible return with the lowest possible risk. However, studies have shown that this is not the case. Instead of being risk-averse, people tend to be loss-averse.

As an example, you can choose from the following two options. Would you rather have an 80 percent chance of receiving $4,000 and a 20 percent chance of receiving nothing or a 100 percent chance of receiving $3,000? When asked, 80 percent of people chose the guaranteed $3,000. The first choice is mathematically the best bet, with an expectation of receiving $3,200 ($4,000 x 0.80), but the individuals polled were not willing to take the risk of receiving nothing even though it provided the best risk/return profile.

The second example is similar, but is from a loss perspective. Would you rather have an 80 percent chance of losing $4,000 and a 20 percent chance of breaking even or a 100 percent chance of losing $3,000? Incredibly, 92 percent of people polled chose the first option. That demonstrates that investors are willing to take the risk of creating even greater losses in the future, as long as they do not have to realize a loss now.

As you can see from these examples, and likely your own answers, our belief that we are all rational investors tends to be a skewed notion. In both instances, the overwhelming majority of people chose the option that was statistically the worst choice.

Much of this irrationality is rooted in human nature, as taking a loss is an acknowledgement of personal error. However, the following table demonstrates the profound impact of what can happen if you increase your risk on the way down in an attempt to avoid realizing an early loss.

Amount of Return Required

Loss Incurred To Break Even

10.0% 11.1%

15.0% 17.7%

20.0% 25.0%

25.0% 33.3%

30.0% 42.9%

35.0% 53.9%

40.0% 66.7%

45.0% 81.8%

50.0% 100.0%

60.0% 150.0%

70.0% 233.3%

Two lessons to be learned from this example are the importance of managing risk and the importance of separating your emotions from your investments.

Starting with risk, the first step is to identify all of the risks that are present in your portfolio. However, with the ever evolving complexity of our financial markets, this can be a difficult task even for investment professionals, let alone individual investors. Some of the key risks that you should be aware of include company, country, credit, currency, inflation, interest rate and liquidity.

Regarding emotional detachment, this is something that nearly every individual investor has difficulty doing. Our financial markets are highly influenced by emotion, specifically greed, fear and optimism. Thus, it is important for investors to remain disciplined in their buy and sell decisions in order to mitigate the emotional impact on their portfolio.

While managing risk and emotion sounds easy enough, for most investors it can be next to impossible to do successfully. In many cases, it is best to leave your investments in the hands of a professional money manager so as to eliminate your personal emotional impact. Moreover, a quality manager will have systems in place to monitor and mitigate risk while still providing superior risk-adjusted returns.

The next time you are discussing your portfolio with your friends or financial advisor, make sure you bring up risk and not just return; both are equally important in achieving your financial goals.

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William Dostman III is senior domestic equity manager for Karpus Investment Management. He can be reached at (585) 586-4680.

Published: Thu, Sep 8, 2011