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Financial Decoder: Season 2 Episode 2

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We all want to earn significant returns on our investments, but a major factor is whether we’re willing to accept the associated risks. Are there biases in the way of our decisions about risk?

Your willingness and ability to take on risk in your portfolio has a significant effect on how your portfolio performs. However, perceptions of risk can be skewed by overconfidence, affective forecasting errors and other biases.

In this episode, Mark Riepe explains how people’s tolerance for risk differs on a cognitive and emotional level, as well as how “risk capacity” is a more objective matter. Tobin McDaniel, Schwab’s SVP of Digital Advice and Innovation, joins Mark to discuss how investors view risk in real-world situations, and how they respond to changing market conditions.

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Financial Decoder is an original podcast from Charles Schwab.

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MARK RIEPE:  In late September, the drug store by my office posts the same sign every year: Flu Shots Available Here. And every year the media reports that the vaccine is relatively effective against the common strains of flu.

The CDC recommends everyone over 6 months of age receive a seasonal flu vaccine.[1] In the 2016-2017 flu season, those vaccinations prevented an estimated 5.3 million illnesses, 2.6 million doctor visits and 85,000 hospitalizations.

There’s no question that flu shots reduce the risk of getting sick, being hospitalized or even death. Yet many people accept the risk of getting the flu versus the inconvenience of getting a flu shot. They walk right past that drug store sign and don’t give it a second thought. Why is that? How is that risk being assessed?

If you’re one of those people who don’t typically get the flu shot, would you feel differently if an unvaccinated friend or family member got the flu one year and became seriously ill because of it?

You likely would, because our perception of the relative risks associated with something—whether disease or financial loss—can be manipulated by our recent personal experiences and biases.

I’m Mark Riepe, and this is Financial Decoder, an original podcast from Charles Schwab.

On this podcast we examine the cognitive and emotional biases that can influence your financial decisions. And we offer strategies to help you mitigate those biases and improve your financial outcomes.

Investing is the art of balancing risk and return. You can’t have one without the other. The investments that have the highest opportunity for return tend to be the ones with the most risk associated with them. And while we all want to make significant sums of money with our investments, the real question is whether we’re willing to accept the associated risks.

Since risk and return are linked a good place to start when making an investment plan is to decide how much risk is tolerable and then figure out how best to maximize return given that level of risk.

That seems simple enough, but there are biases that influence our judgment as to what level and types of risk make sense for us. 

Before I get into those biases, let’s define some terms.

When I mention risk tolerance, I’m talking about the willingness to bear risk, or your emotional comfort level with a decision that has an unknown outcome.

For example, let’s say I’m about to flip a coin and I’m only going to flip it once. I offer you a choice. I’ll pay you $6 if it’s heads and nothing if it’s tails—or I’ll just give you $3 to not flip the coin at all. Most people will just take the $3. Sure, there’s a chance for a $6 payoff if the coin lands on heads, but there’s no guarantee that will happen, and if it lands on tails, you get nothing. People taking the $3 here are risk averse.

If I were to change the rules and make the payment $15 if it’s heads, nothing if it’s tails or $3 no matter what happens, I suspect most people would forgo the $3 sure thing because the upside is so high. Though most people are risk averse, if you make it worth their while, they’re willing to dive in and take the risk.

If risk was as simple as that, then this episode would be pretty short—but as it turns out there’s a lot more going on.

The first issue is that the amount of risk that we’re comfortable taking doesn’t appear to be constant. There are perfectly good reasons for that, of course. It makes sense for an investor who is 75 years old to take on less risk than one who is 35 years old, but what I’m talking about here are reasons that don’t have to do with your life stage or when you’ll need the money.

I’m talking about factors that are driven purely by emotion. One of these is our recent experience as investors. To a certain extent that makes sense. After all, we all learn from our experiences and that’s a good thing. But prior experiences can affect our willingness to take risks in ways that are unexpected.

For example, let’s imagine that you’re a day trader, and by that I mean you’re a person who trades frequently but rarely holds a position for very long. Let’s also imagine that you had a rough morning and are down $5,000. How does this fact influence the risks you’ll take in the afternoon? Do you get more aggressive and make riskier trades to try to make back the $5,000 and break even? Or are you more cautious and choose to make more conservative trades? Maybe you stop altogether and make no more trades that day—and thus take no more risks at all—not wanting to make a bad situation worse.

Before you answer that question, realize that choosing any of the options given means the level of risk you’re comfortable taking has changed.

In the first option, your prior losses make you more aggressive, or more risk tolerant. In the second and third options, your prior losses have made you more conservative, and more risk averse.

Both examples show that the level of investment risk we’re comfortable taking is not necessarily some immutable number.

As it turns out, at least in laboratory settings, people seem to exhibit both behaviors. At first blush that doesn’t seem to make any sense. But, it all seems to hinge on whether the earlier losses were realized or unrealized.

If the losses were unrealized, meaning losses on paper, investors tend to act as if they can get the money back. And so they take on greater risks to catch up. This behavior is driven by the loss aversion that we discussed in the episode “What Should You Sell?” 

On the other hand, if the losses were realized, the damage is done, and the investors, under simulated conditions at least[2], appear content to lick their wounds and be more cautious next time.

Think back on your own experiences either in investing or other situations where risk taking was present. It wouldn’t surprise me at all if you can easily recall situations where you’ve behaved in both ways.

Another issue with risk is that it’s hard to predict what your tolerance for risk will be. The fancy name for figuring out how you’ll feel in the future if a given event happens is called affective forecasting. “Affective” with an “a” means pertaining to emotions or feelings. There is an episode of Choiceology about affective forecasting called “How Tomorrow Feels Today” that I’d encourage you to check out.

Generally speaking people don’t do a great job of forecasting how they’ll emotionally react to a future event that they haven’t experienced before. If I ask you how you’ll react if your investments decline 20%, your answer may not be terribly accurate if you don’t have personal experience with a loss of that magnitude.

A related problem that complicates figuring out how much risk we can bear is that people sometimes don’t truly understand the odds. For example, smoking is a risky behavior from the perspective of health. However, consider children who aren’t aware of the scientific studies linking smoking and lung cancer. In that instance the kids who smoke are engaging in a risky activity, but not necessarily because they are risk seekers. It’s more likely because they don’t know the risk is there, or they don’t understand how serious the consequences of that risk can be. This line of reasoning could also be true of the people who choose to forgo a flu shot every year.

In the context of your finances this is one of the reasons financial literacy is absolutely vital. It’s extremely difficult to make good decisions about how to balance risk and return if you misperceive the risks.

For example, individual investors are often interested in investing in IPOs, initial public offerings; and we routinely hear stories of IPOs that have way more people wanting to buy shares than are able to. Undoubtedly many of those investors are familiar with past IPOs that have gone on to dominate their industries—and generate lots of money for those who got in early. What is less well known are all of the IPO duds.

The result is that studies, on average, show that a portfolio of IPOs tend to either underperform the market over longer periods or at best match the performance of the broader market.[3]

Another example of where perceptions get in the way is when we start thinking about overconfidence. In our last episode we talked about diversification and how diversification is an act of humility because it requires you to admit you don’t know what the future will bring, and so you spread your bets.

What if you believe, due to overconfidence, that you have an exceptional ability to decide which stocks to buy, and thus you concentrate your portfolio?

You are taking on a lot of risk, but it doesn’t necessarily reflect a high risk tolerance. Instead, it may well reflect a skewed perception of your odds of success—that is, your behavior is driven less by an attitude towards risk and more by a perception of ability. There’s a similar effect with some people who don’t get flu shots. They think “I never get the flu, I never get sick, why do I need a shot?” Perhaps they have a medical basis for that, or perhaps it’s overconfidence.

An extreme example of this is Philippe Petit. He’s the guy who walked on a tight-rope between the World Trade Center Twin Towers in 1974. Most people would consider that pretty risky, but in an interview Petit said, “Death frames the high wire. But I don’t see myself as taking risks. I do all of the preparations that a non-death seeker would do.”[4]  

Think about that for a moment. He recognizes that tight-rope walking is a high-risk activity, but not necessarily for him after all of his training and preparation. And he’s right, of course. The problem comes in when you or I think about the riskiness of an activity and we overestimate our own skills.

A more recent example is the documentary Free Solo in which climber Alex Honnold climbs El Capitan in Yosemite Valley without ropes. Honnold says that because of his skill and experience, free-solo climbing isn’t high risk for him—it’s just “high consequence.”[5]

To help explain more about how these biases can influence risk, I’m joined by Tobin McDaniel. Tobin is a senior vice president at Schwab, and he’s in charge of the Digital Advice & Innovation area.

Tobin, this episode is about risk and you’re in the unique position to see how real people think and more importantly act when it comes to risk. Can you describe some of the processes you go through to make that risk assessment?

TOBIN MCDANIEL: Thanks, Mark. We do have an interesting view into how investors think about risk. And as context, when we talk about digital advice at Schwab, that’s Schwab Intelligent Portfolios, where investors go online, answer a few questions about their goals, their risk tolerance, their time horizon and we make a portfolio recommendation for them and then manage that portfolio for them over time. We can see how those investors first answered the questions and then react to changes in the markets. We’ve had over 300,000 accounts opened, so we have a really broad data set to see how people do react to risk.

MARK: So 300,000 people have gone through the process at this point. How distributed are they across the risk spectrum?

TOBIN: We have a broad distribution. When we talk about our risk spectrum, we generally mean we have 12 portfolios, and they go from most conservative to most aggressive. And when you look at our client base, they center around moderate-aggressive. Fourteen percent of the accounts are conservative, 51% moderate, and 33% are aggressive.

MARK: And so by conservative, you mean portfolios that have more bonds, more cash, much less equities, and so they tend to be less volatile over time. And the aggressive portfolios are very stock-heavy, a lot more volatile.

TOBIN: That’s right; the most conservative portfolios are very much oriented toward fixed income; the most aggressive are high-growth, almost all equities.

MARK: One characteristic about risk assessment that’s intriguing is that studies show that risk tolerance isn’t constant over time—especially in the presence of losses. Some of the digital advice solutions you were just talking about, they give people the option to update their information and those updates could potentially result in a new risk assessment or a new recommendation. When you’ve looked at the data, do you notice any patterns in terms of when are people revisiting their answers and how often they’re getting new assessments?

TOBIN: Well, clients can go in at any time and update their questions on our website or the mobile app and get a new recommendation. And the first patter we see is that regardless of what’s happening, there’s always a steady beat of clients coming and making some changes. It’s a little less than 1% a month, but people are always coming in and re-answering. The other pattern we see is when the markets do get volatile—think about the fourth quarter of 2018—that ticks up a little bit. It ticks up to a little over 1% of people coming in, re-answering questions and making changes to their portfolios.

MARK: So, how are they actually doing that? What does that actually look like in practice?

TOBIN: What it looks like in practice, and what it looks like in practice in the rocky markets, is actually a few things. One, clients are just checking on their accounts more. Two, they’re more likely to call us to ask questions, and actually they’re more likely to either make deposits or withdrawals, depending on how they view the markets. But when it comes to their risk assessment, that little over 1% that actually go in and make changes to their profile, roughly half of those clients end up more aggressive, and roughly half end up more conservative, so you can see clients on both sides of the scale.

MARK: There’s a really interesting episode of Choiceology, the Choiceology podcast, where we talk about algorithm aversion and the fact that people can be sometimes reluctant to let an algorithm make a decision for them, but if you give that person some element of control or an opportunity to kind of take over the wheel, they become much more accepting. So when we make recommendations to clients, do you see any of that?

TOBIN: Yes, we do see that and we support people in getting over that aversion in a couple of ways. First, investors have the ability to make a change to the recommendation that we gave them, you know, on that scale of conservative to aggressive, from 1 to 12. Investors can move up one notch or down one notch, based on what we’ve recommended. The other thing we can do, and that we see some investors do, is they just call us. They’ve gotten their recommendation, they feel good about the answers they’ve given, but to paraphrase one investor who called in, “I just wanted to see who’s behind the computer, who’s behind the algorithm making this thing tick” just to feel comfortable that it’s going to manage their money the way they want it to.

MARK: So how often are clients sticking with the initial recommendations? And you mentioned some people move it up in aggressiveness, some people move it down. How often is that happening?

TOBIN: Two-thirds of the time people stick with our initial recommendation, and the other one-third of the time it’s fairly equally split between people who choose to move a little more aggressive and people who choose to move a little more conservative.

MARK: Tobin, thanks for being here. We cover a lot of academic studies on this podcast but it’s always nice to have a real person talking about real clients making real decisions.

TOBIN: Thanks for having me, Mark.

MARK: Let’s wrap up with a few recommendations for how to think about risk in a smarter way.

First, think about risk in all of its forms and make sure your investments reflect the risks that would impact you the most.

For example, one survey asked[6] moderately affluent individuals what investment risk means to them. Forty percent equated investment risk with a large loss, and by that they meant a loss of principal or a big negative return. Another 18% equated investment risk with a return below some sort of target or desired return.

The fact that those two responses came out as the most popular reflect an overly narrow interpretation of risk, and perhaps that’s because of the fact that the question was phrased as being about investment risk. But as we’ve said, for most people your investments are meant to serve a larger purpose, which is to help you achieve your goals.

Therefore, it would be a mistake to simply focus on the risk of loss over the next year if your goal is to spend the money from the portfolio decades from now.

Up until this point we’ve talked mostly about the emotional aspects of risk and finding that point where our emotional comfort-level exists.

Prudent risk taking isn’t just about emotions, however. There are more objective factors to consider, and these help balance the messy, ever-fluctuating emotional aspects of the decision.

One way of thinking about it is to divide these factors into two categories. Let’s call one risk “willingness” and the other risk “capacity.”

Think of risk willingness as a set of emotional factors. How much angst do you suffer as you watch the prices of your investments fluctuate? If you suffer a lot of angst, then your risk willingness is low.

On the other side we have risk capacity. These are objective factors that are independent of your emotions.

For example, if you have $10 million in your retirement portfolio and expect to spend only $50,000 of it per year when you actually retire, then you have a fair amount of capacity to take on risk. In other words you can afford to take on higher levels of risk because even if your investments perform poorly, you have a large margin for error.

If your retirement date is 30 years away, you also have a higher capacity for taking on risk because you have lots of time to make up for any short-term periods of poor performance.

On the other hand, someone who is planning to spend large chunks of their portfolio in the near future has a much lower risk capacity. Even if they can emotionally tolerate it or are willing to bear risk, that needs to be tempered by the fact that their situation warrants a higher degree of caution.

Both sets of factors, risk willingness and risk capacity, matter when it comes time to make an actual decision.

You should also consider the risk factors of your spouse or partner when making these decisions. For example, if one spouse is younger than the other and also has a longer life expectancy, that means there is higher risk capacity for that individual. Couples may also have differences in their risk willingness. Don’t default to either the most aggressive or the most conservative partner, or to the risk willingness of the person who is supposedly “in charge” of the investing for the family.

My final suggestion is, don’t overreact one way or the other in response to recent market activity. One phenomenon that we’ve explored is when people increase their level of risk to make up for losses.

Think of the person who sees the market drop a lot and they immediately ratchet up the risk level. At the other extreme are people who experience a loss and who immediately get super conservative and lose sight of the risks associated with that, which can be particularly risky if they’re a long-term investor who has plenty of time.

It can make sense to take more risk if the market overreacts on the downside. It can also make sense to become more conservative if a loss has caused you to see your true risk tolerance more clearly. These are complicated decisions and shouldn’t be made quickly or on a whim.

If you’d like to learn more about risk, consider taking Schwab’s automated investing questionnaire to get your own risk profile. Check it out at schwab.com/automatedinvesting.

Also, please share your thoughts and ideas on the direction of the show, and give us any feedback: Please take the survey available at Schwab.com/Survey to have your say. There’s also a link to the survey in the show notes.

Thanks for listening. If you’ve enjoyed this episode, consider leaving us a review on Apple Podcasts or your favorite listening app. It also helps others discover the show.

For important disclosures and a transcript, see the show notes at schwab.com/financialdecoder

 

[2] Alex Imas, “The Realization Effect: Risk-Taking After Realized Versus Paper Losses,” American Economic Review, 2016.

[3] Jay Ritter, “The Long-Run Performance of Initial Public Offerings,” Journal of Finance, March 1991, pp. 3-27, and Paul Gompers and Josh Lerner, “The Really Long-Run Performance of Initial Public Offerings: The Pre-NASDAQ Evidence,” Journal of Finance, August 2003, pp. 1355-1392.

[4] Carlin Flora, “Fluke Skywalker: Philippe Petit,” Psychology Today, January 2007.

[5] Legendary Climber Alex Honnold Shares His Closest Call, https://www.nationalgeographic.com/adventure/adventure-blog/2015/12/30/ropeless-climber-alex-honnolds-closest-call/.

[6] Robert A. Olsen, “Investment Risk: The Experts’ Perspective,” Financial Analysts Journal, March-April 1997.

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