Assessing Risk Appetite

It is typical in the investment industry to look to determine what an investor’s comfort level with risk is. This is a subjective measure where potential investors will be told to contemplate certain drawdown amounts in their portfolio, like 25% or 50% and assess what their comfort level would be if their portfolio declined by given amounts.

At first glance at least, this appears to be a great idea, because investors do not want to exceed their comfort level, and those selling the investments do not want to see their clients liquidate their positions under duress and quite possibly take their money elsewhere.

Investors do not tend to be particularly impressed with large drawdowns and tend to blame their advisors and investments more than they blame the market, and this certainly does not leave the funds or the advisors looking very good regardless.

Selling under duress, after experiencing large drawdowns in their positions, also tends to produce a lot of poor trading, where the clients have taken the bull by the horns and generally do not know what they are doing and will be prone to making mistakes.

An investor may lose half of their portfolio and liquidate it, and then watch the market move up without them. They may have hung on for a long while when it would have been more sensible to get out, and they then may get out around the time it was sensible to get back in.

Their advisors may end up telling them that they should have just stayed the course as they are so often told to do, and this may end up conditioning them to accept even more risk, more than they are comfortable with, in an effort to manage bear markets better. This may or may not do so and it may end up making things worse.

What Is Wrong With This Picture?

It is definitely good to assess an investor’s risk appetite, and this does tend to differ among individual investors by a significant degree. Some will be able to handle large drawdowns in their position, while others may fret over relatively minor ones.

Due to the fact that potential return and potential risk are generally inversely related, what happens is that those investors with the lowest risk appetite will be assigned investments with the lowest potential returns, and the investments that will be recommended will be dependent generally on one’s threshold of pain basically.

If one is seeking market returns for instance, the stock market in other words, if one is not willing to endure the large sized bear markets that come with this territory, then this sort of investment would be found to be unsuitable.

Depending on one’s risk tolerance, one may be assigned various asset mixes, from having one’s entire portfolio stuck in the savings class of assets, money market funds and certificates of deposit, to having one’s entire portfolio put into stocks, perhaps even in funds that are more aggressive.

This might seem reasonable until we consider that the assumption this all makes is that there is only one option, to stick with whatever is selected for you regardless of the circumstances, on other words to just buy and hold.

If we are concerned about risk, we might want to look to manage it other ways, like for instance to being more flexible and changing our asset mix not to just suit our level of pain, but to suit the conditions of the market as well.

Investment sales people discourage this of course, they don’t want you switching like this, they don’t want you doing anything but just taking their advice and then just hanging on to whatever they recommend. This is the ideal scenario for them, and they realize that people are going to play around with their portfolios from time to time, but they seek to minimize this.

Depending on the circumstances, buying and holding might be a good plan, but this is going to depend on the circumstances,  If these circumstances are held to not matter, to never matter, that means that one must be prepared to take on the risks involved in this.

Risk Is Not So Static Though

There are many traders who would be absolutely horrified with getting stuck with a position overnight, because they see this as far too risky for their tastes. In a real sense, overnight positions can indeed be seen this way, as while the market is closed all sorts of things can happen which can result in a position opening lower, while actively managed trades can manage these risks by getting out at a desired point when things start to go south.

This is far from the realm of longer term investing of course, but it is certainly true that the length of time a position is held is positively correlated with the risk of the investment. To hold a position longer term, you can’t just get out of it when it declines a fraction of a percent, or even a few percent, you have to be willing to ride the bumps that all securities encounter along the path to wherever they are headed.

Therefore, one can manage risk by looking to reduce one’s time horizons as desired and appropriate, allowing for tighter exit signals and reduced risk.

In order to manage risk properly, we do need to have a threshold, where our risk appetite gets exceeded, but this does not mean that we need to always avoid investments where the strategy of totally ignoring risk management might exceed our risk tolerance.

That’s how investments tend to be sold though, the ignoring risk is a given, and if you can’t stand the heat this generates, you are told to stay out of the kitchen basically.

There are investors such as Warren Buffet who have done extremely well with the buy and hold strategy, but even Warren assesses his investments over time, and his risk tolerance is much higher than the average investor. If Buffet sees his portfolio decline by 10 or even 20 billion, that’s not going to bother him, he has enough left to live many lifetimes extremely comfortably no matter what happens.

Average investors, on the other hand, are trying to put together enough money so that they can live comfortably period, in this lifetime, and whether or not they will be able to achieve that tends to be much more uncertain.

What The Decisions Come Down To Here

If an extended bear market will dash your plans, then your risk tolerance may not be as high as you think, although the solution isn’t necessarily to just put all your money in 30 year treasuries and try to survive in your old age on the returns they produce, perhaps never making it to where you need to be to avoid a life of financial struggle.

The risks involved in looking to build one’s investment portfolio over time do need to be accounted for, and we need to do so more or perhaps even much more than is typical.

If investment risk can be managed with proper asset allocation, and we look to do this initially, why not use this tool to manage our asset allocation on an ongoing basis?  Would this not manage risk better than the static approach we tend to use typically?

The problem is that asset allocation has become a subjective standard rather than an objective one, dependent upon how much risk we are comfortable with, rather than what the proper thing to do at any given time may be.

If we’re in the midst of a bear market for instance, where stocks are performing poorly and appear to likely continue to do so for the foreseeable future, why would we want to stack our portfolio or keep it stacked with positions that run contrary to this trend?

If the bond market is doing better at this point, going up instead of down, wouldn’t it be better to manage risk by moving more or maybe even all our portfolio to bonds?  Perhaps both are doing poorly and are both too risky at this point in time and we may be better off with our money in savings, in essentially risk free instruments?

Viewing Risk Management Dynamically

Risk with investments are not static, meaning that a certain type of investment has a constant degree of risk, stocks for instance, or bonds. We can speak of the risks of such things generally, such as stocks are riskier than bonds generally because they are more volatile, but the risk of a given investment is also specific to the present circumstances.

Both of these matter, how volatile an investment is generally and how volatile it is now, as well as the current direction of the investment. That’s actually the most important consideration in risk assessment, as volatility in the direction of our trade is desirable, where the opposite is the risk that we actually have to manage.

One always chooses the degree of risk that one wishes to take on in any investment or trade, and this is also dynamic, where the amount of risk that is actually taken on does not depend as much on the type of investment as it does the type of strategy used.

Risk can be managed with even the most volatile of investments, provided that one actively seems to manage them. If you don’t want to lose more than 1% of your investment, you can trade virtually anything and manage this, because you just exit the trade when your tolerance has been exceeded.

Investors need to set much higher tolerances than this though, but we do get to choose this, and this is what we need to be focusing on when we apply our risk appetite to investments. It is not so much what to invest in and what to not invest in as it is how far we are comfortable with these investments going against us.

Timing investments are seen by the investment industry as something to be avoided, yet with investments, timing is everything, and this is the main tool that we have to manage their risk.