While there are many aspects of life where an individual must assess risk, financial risk is something which most individuals fail to evaluate correctly.
This is mainly due to the complexities involved in assessing risk, such as:
- Technical jargon surrounding the subject of risk – Standard deviation, Sharpe ratios, Treynor ratio, etc.
- Inability to articulate what is the trade-off – everyone is looking for an investment with zero risk and maximum return
- Difference between my actual behaviour and professed behaviour
- Hearsay Bias – News and stories that we hear about people making significant gains or losses
To simplify the process, let’s elaborate these 4 Risk identification and analysis factors below:
Jargon – a few misnomers
The most common statistical measure used to evaluate risk is volatility i.e. price variation on both upside and downside. So, if something has zero volatility, it basically means that there is neither upside nor downside. Frankly speaking, we all want upside volatility (positive surprise). What we do not want is negative volatility. The second issue is that this is statistical in nature. It does not mean that it may never happen. For example, we may put money into a fixed deposit (no upside or perceived downside risk to capital along with fixed interest, hence volatility is zero), but what happens if the bank goes bust? Even if the chances are very remote, they still exist.
Therefore, we need to clearly understand risk in terms of how much downside risk is present, and what is the probability of that.
Trade-Off
Simply put, what is it that we are willing to give up in the hopes of getting something more. This is the philosophy that “There are no free lunches”. The most important factor seems to be “Recency Bias”. This works both ways:
When things are rosy - we think we can take higher risk, because we feel that the future is going to be great and it is “unlikely” that there will be a negative outcome or downside.
Similarly, when things are gloomy – we tend to be more pessimistic and expect the situation to deteriorate further. This often leads to panic selling and we tend to forget the “time horizon” that we had invested for.
The very fact that we are promised a higher return is that the probability of that return is not 100%. More importantly, there is a probability that the principal may erode. This is also the reason that we do not put all our eggs in one basket, however lucrative they may sound. There are no “sure-shot” winners.
The other very important factor to consider is time. The trade-off on the return could be that we need to be patient to see the results that we have planned for. And during this period, we could see down-swings (or volatility) in our investments.
Actual Vs professed behaviour
Even the best financial plans and decisions face the uncertainties of the future. While financial investments hardly behave as predicted, how we react to it, also may differ from what we anticipated. The wider the deviation from what was “predicted”, the more we question our past decisions.
Hearsay bias
We live in an age where news flow is constant – to the point that it becomes noise. Filtering the noise and making informed decisions become extremely difficult, especially in times of stress. This takes many forms, main among them is FOMO – Fear of Missing Out, on some action that “others” are taking.
Due to the above reasons, the normal risk profiling that everyone does – “Conservative”, “Balanced”, “Aggressive”, etc. does not work. Partially also because they have connotations that go well beyond the narrower scope of financial risk we are trying to quantify.
We seldom assess the real-life financial expectations on risk – beyond some questions that are routinely asked – to “gauge risk” through psychometric profiling. This is used to derive a score that helps to categorize individuals in various risk profiles such as conservative, balanced, aggressive, etc.
How to quantify the category, so that it translates into a model portfolio, is seldom really done.
There are a set of few very specific questions which can address the below concerns:
- What is the maximum loss that I am ready to see on the principal over a specified period?
- For taking this risk, what is my return expectations?
- Time horizon?
- How much short-term erosion of principal that I am willing to see, in the hopes of long-term gains?
These inputs can be used to quantify and create the financial framework which can describe the characteristics of the portfolio we want. Creating this framework is the starting point for any investor as it will help tide over extreme short-term volatility which leads us to question: What should I do now? Apart from this, it can also be used for following reasons:
- Creating an actual asset allocation of our portfolios
- Monitor the portfolio
- Periodical reviews of the portfolio
- Incorporate changes in the portfolio for new opportunities, products and financial goals
Risk management is a vital step in planning financial strategies and monitoring the portfolio. This often allows to eliminate the potential risk involved and provides ways to diversify the investment options depending on the goals of Investors.
George Mitra is the CEO and Co-founder of Fintso. The views expressed in this article are solely of the author and do not necessarily reflect the views of Cafemutual.