Be careful what you 'risk' for
Risk stands in the middle of one of investing’s greatest mixed metaphors.
“Curiosity killed the cat.” However, it might not have, if you hadn’t “let the cat out of the bag” in the first place. That cat should have never accepted the offer to leave the bag anyway. You know what they say about “Greeks bearing gifts.”
Those metaphors work relatively well together. On the other hand, you’ll no doubt cringe in consternation when someone says, “Beware of Greeks bearing curious cats.”
This is an example of a mixed metaphor. And a mixed metaphor can be a very dangerous thing.
Especially when it comes to making financial decisions.
Related: The link between financial risk and benefits selection
Risk stands in the middle of one of investing’s greatest mixed metaphors. On one hand, we have the hallowed concept of the risk/return tradeoff. On the other hand, we have the idea that people should assess their risk tolerance before investing.
The trouble is, we’re talking about two different kinds of risk here. In the first instance, when we speak of the relationship between risk and return, we allude to a theoretically objective construct that exists solely within the framework of a specific investment. In the second case, the risk in “risk tolerance” refers to a subjective feeling solely confined within an individual’s brain.
The real problem occurs when practitioners and investors try to mix these metaphors. This, in fact, exposes the fallacy of trying to manage investments via any factor involving personal risk tolerance.
If you need to earn 5 percent to meet your goal, you can’t let your fear of volatility limit your investments to CDs yielding, well, hardly anything. In other words, if you need the ball to land on red at the roulette wheel, you’ll never win anything if the only thing you bet on is black.
The practice of relying on risk tolerance questionnaires took off in 1999 following the Financial Services Review publication of John Grable and Ruth Lytton’s risk-tolerance scale. The implication is that risk tolerance has a valid place in making investment decisions.
At that time, there had been only a handful of academic papers published attempting to equate decision-making with emotions. By 2014, a full 30 percent of all published psychological research dealt with this subject. Needless to say, we’ve come a long way since 1999.
One thing is clear: Emotions drive decisions. Of note, though, is this: Emotions don’t drive small-money decisions. When it comes to big-money decisions, however, lower-income classes are more likely to make emotional decisions.
We often see emotional decision-making among 401(k) investors. Recall how fear caused so many to sell their equity investments following the 2008-2009 market crash. They couldn’t tolerate the “risk,” so they went with the “safe” choice.
Said another way, they bet on black when they really needed red.
Remember, those who bow to the Modern Portfolio Theory altar know you won’t get the return if you don’t take the risk.
Actually, that’s not really what that theory says.
Oh, well. I guess we’ll burn that bridge when we come to it.
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