Paying an excess premium to avoid uncertainty
Many investment decisions are made in face of uncertainty. We often don’t have enough facts to calculate odds of success or failure with any accuracy. But, it’s still best to invest by looking at probabilities.
As Warren Buffett said at the Berkshire Hathaway Annual Meeting in 1989: “Take the probability of loss times the amount of possible loss from the probability of gain times the amount of possible gain. That is what we’re trying to do. It’s imperfect, but that’s what it’s all about.” Probabilistic thinking is a good way to address risk.
But, even at the best of times, humans are bad at assessing probabilities. Worse than that, even if we have a good sense of the probabilities, we can make investment mistakes because of risk aversion or risk seeking behavior. That is, we ignore or downplay the probabilities. What are these two terms and how do they hurt us?
Risk aversion does not have the hazy meaning of somehow not liking to take risks. Risk aversion is specifically an unwillingness to take on a risk in spite of the fact that the reward amply justifies the risk taken. Similarly, risk seeking has a specific meaning. Risk seeking is taking on a risk in spite of the reward not justifying the risk taken.
Risk aversion and risk seeking behaviors are pathological. They result from behavioral biases and cognitive errors. They are to be distinguished from risk taking and risk management. Risk taking is a normal, even essential, part of investing. An example of risk taking would be the purchase of common shares in a company. Since the outlook for common shares is, for all intents and purposes, always uncertain, one is always taking a risk when purchasing common shares. Similarly, bond investors face risks like inflation and default.
The writer prefers the expression ‘risk sense’ as the term to describe an appropriate sense of risk. It would be akin to the expression ‘common sense’. One might describe someone as exercising common sense. One might also describe someone as exercising risk sense. Using risk sense is risk management.
Risk aversion and risk seeking are flip sides of the same coin and are both are characterized by Kahneman as involving the “consistent overweighting of improbable outcomes – a feature of intuitive decision making [that] eventually leads to inferior outcomes.” (Kahneman, 2011)p.321.
Greed and fear
It is often said that investors are mostly driven by greed and fear. The truth is more nuanced. The average investor is generally not driven by greed. As Kahneman puts it: “…the main motivators of money-seeking are not necessarily economic.” He adds: “…money is a proxy for points on a scale of self-regard and achievement. These rewards and punishments, promises and threats, are all in our heads. We carefully keep score of them. They shape our preferences and motivate our actions, like the incentives provided in the social environment. As a result, we refuse to cut losses when doing so would admit failure, we are biased against actions that could lead to regret, and we draw an illusory but sharp distinction between omission and commission, not doing and doing, because the sense of responsibility is greater for one than for the other. The ultimate currency that rewards or punishes is often emotional, a form of mental self-dealing that inevitably creates conflict of interest when the individual acts as an agent on behalf of an organization.” (Kahneman, 2011)p.342. This is thought provoking stuff! Kahneman references are to Thinking, Fast and Slow. Doubleday Canada division of Random House of Canada Limited.
Greed’s companion is fear. As investors, rather than dwell on our fears, we are further ahead to examine our feelings about risk. So let’s change our vocabulary and thinking when we reflect on what is driving us as investors. We can replace the idea of fear with that of risk aversion. We can replace the idea of greed with risk seeking.
Let’s look at a few examples.
Early bad experience
A novice investor might take a bad hit early in their investing career and become afraid of common stocks for the rest of their lives. We have apparently derived from our ancestors a “great facility to learn when to be afraid. Indeed, one experience is often sufficient to establish a long-term aversion and fear.” (Kahneman, 2011)p.237. Our novice investor will have developed a tendency to ‘overweight improbable negative outcomes’. They have developed an ingrained risk aversion towards stocks.
Fear of failure is the opposite of over-confidence. Many young people never learn how to lose. Sports and games, such as card games, are a great place to learn about losing.
Templeton stresses that you won’t always be right. “In order to be flexible in investment management and preserve your freedom to shift around, you can’t expect that every decision you make is going to be right. But the net result over twenty or thirty years is going to be better than if you didn’t try to be flexible.” (Proctor & Phillips, The Templeton Touch, 1983, 2012)p.106.
Psychological impact of luck
Most people recognize that there is a big psychological element in sports. Some teams even have sports psychologists on staff. Random luck can have an impact on a team. A late game lucky goal from a puck or ball that takes a crazy bounce can pick up a team’s spirits or dispirit the opposition.
Luck plays a very significant psychological role in investing. Remember, we can have a lucky outcome from a poor decision. And we can have an unlucky outcome even when the investment decision was sound. What are the consequences of this? The two most important are: First, an investor may interpret a lucky outcome to be the result of skill. This can lead to over-confidence and hubris (from which nemesis) – a deadly situation. The outcome is risk seeking behavior. The ancient Greeks were onto this. According to Herodotus, who wrote his ‘Historia’ in about 440bc, mans’ fortune is unstable and hubris is succeeded by nemesis (inevitable retribution) i.e. a Greek tragedy. Even skilled investors succumb to the sin of pride when things have gone well for a while, when an objective view would see that luck played a big part in things going well. Fortune may favor the bold, but it also cuts risk seekers off at the knees. Second, an unlucky outcome or a short run of bad outcomes can lead the investor to become disheartened – this can lead to risk aversion or even to abandoning investing altogether.
Selling a stock too soon
Selling a stock too soon i.e. over-trading, violates Warren Buffett’s advice (“Inactivity strikes us as intelligent behavior”). It also comes freighted with a variety of emotions. The mental account Kahneman refers to includes our remembering what we paid for the stock and how much our paper profit is at the moment. Many investors fear that stock market volatility and other unknown dangers will rob them of their gains. This fear is a powerful motivator. The investor has a handsome gain in a stock. The last thing they want is to give that up in a volatile market. They sell and lock in a gain. Their motivation is probably a combination of satisfaction in seeing their astuteness as a stock picker confirmed with tangible proof and relief in avoiding the regret they would have suffered had the stock price gone down and they had suffered a loss. Fear of losing their paper gain has made them risk averse.
Selling losers and fear of getting whipsawed
Holding losers can initially lead to risk averse behavior and, as the potential loss deepens, may lead to risk seeking behavior.
You invest in a stock after thorough analysis and make a careful decision to buy. The company’s business doesn’t perform the way you expect and the stock goes down in price. If you sell the stock, will you regret it? Regret is a powerful force. You may feel that if you continue to hold the stock your potential for regret will be less. The price may bounce back. You realize the company’s business is underperforming but are afraid of taking action. As Kahneman writes: “people expect to have stronger emotional reactions (including regret) to an outcome that is produced by action than to the same outcome when it is produced by inaction.” He goes on: “The asymmetry in the risk of regret favors conventional and risk averse choices.” (Kahneman, 2011)p.348-349. You hang on because of a risk averse choice.
But it gets worse. If the stock continues to go down, you may feel you have to do something more aggressive to recoup the loss. This may lead to averaging down, a high risk proposition. It is risk seeking behavior.
Paying a premium to avoid uncertainty
Paying a premium to avoid uncertainty in large measure explains the risk premium attached to equities as against risk free United States Treasury bonds, the Equity Risk Premium. That is, bond investors are willing to forego the higher return from stocks to avoid the uncertainty of stocks. Yes, stocks are more risky than bonds, but not enough to explain a large Equity Risk Premium. In point of fact, excessive reliance on risk free bonds is risk averse behavior in the sense we have defined it. The interesting feature of this risk averse behavior is that the level of risk aversion and hence the Equity Risk Premium varies with market conditions. At times of low investor confidence Mr. Market becomes more risk averse and drives up the risk premium attached to equities. That is, equities become relatively less expensive. The irony is that, when the risk premium is higher, this is exactly when the risk of equities is lower and they can be purchased with a higher margin of safety.
The level of risk aversion moves markets. 2008 was a traumatic year. As reported by the Economist Magazine November 10, 2012, “According to EPFR Global, a data provider, bond funds have attracted…almost $1.1 trillion since the beginning of 2008. In contrast, equity funds and money-market funds have seen net redemptions of $467 billion and $793 billion respectively since the start of 2008.” It should be remembered that 2008 was the year the U.S. subprime financial crisis struck and the stock market tanked and that through 2012 there was an unrelenting sovereign debt crisis in the Euro zone. Mr. Market became more risk averse and shifted money away from the uncertainty of stocks and into the relative certainty of bonds. In point of fact, stocks could have been purchased in March of 2009 with a higher margin of safety than at any time in the last twenty years.
Investment advisors can be risk averse because of client, career and peer pressures. As John Maynard Keynes put it succinctly in The General Theory: “Worldly wisdom teaches that it is better for reputation to fail conventionally than to succeed unconventionally.” (Keynes, 1936,2007)p.158. Conventional investing is risk averse. Conservative investing is investing with risk sense.
These are just a few examples.
Risk aversion and risk seeking behavior are typically caused by behavioral biases and cognitive errors. The best way to counteract them is to develop rules or policies you follow at all times. For example, you should ignore what you paid when deciding whether to buy more, hold or sell a stock. What you paid for a stock is utterly irrelevant. Change the Reference Point. Focus on intrinsic value. Another rule is to make sure you learn something from every mistake. That is, you must consciously treat each and every mistake as a learning experience. The Motherlode has many of these rules. I call them Gap-to-edge rules. They are listed at the end of each chapter in the Motherlode. The are also in Appendix 3: Gap-to-Edge Rules.
Other posts on investment psychology
This post is part of a series. Readers are invited to read Investment psychology explainer for Mr. Market – introduction This will give you a better understanding of some of the terms and ideas and give you links to other posts in the series.
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Click here for the Motherlode – introduction.
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