How much risk should you take?

To start things off I want to offer you two scenarios.  Each scenario is going to provide you with two options you can choose from.  After you've completed reading scenario one, make your choice before moving on to scenario two.

Scenario 1

Imagine you could win a guaranteed $3000 or you have the option to take a gamble where you have an 80% chance of winning $4000 and a 20% chance of walking away with $0. Make your selection below: Guaranteed $3000 Gamble with a 80% chance to win $4000 and 20% chance to win $0

Scenario 2

Imagine now that your two choices went something like this; you can have a guaranteed loss of $3000 or you could take a gamble with an 80% chance of a loss of $4000 or 20% chance of losing nothing. Make your selection below: Guaranteed loss of $3000 Gamble with a 80% chance to lose $4000 and 20% chance of losing $0

If you're like most people you probably chose option A in scenario 1, and option B in scenario 2.  It turns out both of those decisions from a probability standpoint were completely wrong. In scenario one, option B offers you an 80% chance of winning $4000 and a 20% chance you'll win nothing.  When you look at the expected return results the math works out like this (0.80x$4000) + (.20x$0) = $3200.  If you played out this scenario 100 times and always selected option B, your winnings would average out to $3200 each time. The gamble in scenario 2 your average loss will be $3200 (the same math applies).  Knowing this, it should be clear that if on average by taking the gamble you lose $3200 and you have a guaranteed loss of $3000, from probability standpoint option B is the better choice.

So, what's going on?  Why do people naturally make the wrong choice when provided these options? It's a little thing called 'loss aversion' which was famously studied and introduced by psychologists Daniel Kahneman and Amos Tversky, who developed the theory that people feel losses twice as much as they feel an equal size of gain.  A $100 loss has two times the emotion that comes with receiving a $100 gain.  This explains why we're willing to risk it all to avoid a loss altogether in scenario 2 (even though it was only a 20% chance) but take the sure thing of $3000 in scenario 1 even though the gamble would have likely payed us more.

In financial planning and investment management, loss aversion creates an interesting problem with clients who believe they are tolerant of risk. Our willingness to take on risk, which is what most investor questionnaires measure, can be much different than one's loss aversion, contrary to the thinking that someone with high risk-taking tendencies and experience would be more willing to accept losses. The problem lies in that measuring how tolerant someone is of risk is greatly affected by their recent experiences.  

Ask a person who just lost 40% in the 2008 financial crisis to take a risk profile questionnaire, and you'll probably find someone who is unwilling to take on even the slightest risk.  Ask a person who's been investing since 2010 and has seen markets climb since the crisis and you'll likely find someone a lot more willing to take risks. Although our willingness to take risks changes over time, generally how we feel losses remains relatively constant. If it changes – it changes at a much slower rate.

As of July 24th, 2019, going back ten years, investors have been rewarded for taking risks with an average annual return of 11.92% from the S&P 500 index.  As a result, investors today are probably feeling quite comfortable with risk as their recent experiences have rewarded them for it.  History however shows that these returns will not continue forever. The fact is just because our willingness to take more risk has increased doesn't mean that the pain we feel when we lose money is any less.  

It becomes a big problem when you see your portfolio drop 20% or more and you begin making decisions based upon the emotions resulting from your losses.  Investors often sell out of some, or all their investments when it is exactly the wrong time to do so.  This mistake becomes even more costly when the feeling from your losses, combined with your new LACK of willingness to take risks, takes you out of the market for extended periods in time.

Endeavour Wealth believes in the power of comprehensive planning. Traditional financial planning bases everything off spreadsheets and numbers, forgetting that there is a human being on the other side. Advising clients on their finances and investments requires good advice, but good advice alone is not enough.  It's why we spend a lot of time with our clients trying to understand how they think and feel about money.  It's easy to provide good advice based upon numbers, but if your clients don't stick to the plan, was the advice effective?

Effective advice goes deeper than risk tolerance questionnaires and spreadsheets.  Effective advice is about putting together a plan that takes into consideration your feelings towards money.  Although loss aversion can be tough to measure, you can get a better sense through meaningful discussions and reviewing your plans and portfolios you currently have in place on an annual basis.  The better you understand your loss aversion, the better you can design a portfolio and plan that you can stick with, ultimately leading you to your goals, whatever they may be.

- Brandt Butt, Investment Advisor

Brandt Butt is an Investment Advisor at award winning firm Endeavour Wealth Management with Industrial Alliance Securities Inc. Together with his partners he provides comprehensive wealth management planning for business owners, professionals and individual families.

This information has been prepared by Brandt Butt who is a Investment for Industrial Alliance Securities Inc. (iA Securities) and does not necessarily reflect the opinion of iA Securities. The information contained in this newsletter comes from sources we believe reliable, but we cannot guarantee its accuracy or reliability. The opinions expressed are based on an analysis and interpretation dating from the date of publication and are subject to change without notice. Furthermore, they do not constitute an offer or solicitation to buy or sell any of the securities mentioned. The information contained herein may not apply to all types of investors. The Investment Advisor can open accounts only in the provinces in which they are registered.