Dynamic Risk Aversion – Why We Sell when the Markets are Crashing

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24 Jan Dynamic Risk Aversion – Why We Sell when the Markets are Crashing

Oh how the mighty has fallen!

In the recent months, global stock markets has seen quite a rout. The STI is down almost 30% since April 2015, Shanghai has given up more than half of its gains, moving from above five thousand points to below three in the past six months. The previous few weeks have seen particularly volatile markets.

Over the past week, it is not the markets that bothered me. Rather, it was a call from the bank that made me very uneasy.

It started off innocent enough. Service call she said, and in between asking how I was, she sneaked in a by-the-way question – ‘oh, by the way, your investments are not doing so well. Would you like me to do a review for you?’

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I declined the invitation. The last I checked, the only investment I hold with this particular bank is my STI ETF which I am buying on a dollar cost averaging program. I relish the thought of markets dropping more, because it would mean each dollar gets me more STI. I shudder at the thought of being persuaded to forgo this investment at this critical juncture.

While the retail investor in me finds pride in staying true to course in my investment objectives, the finance blogger part of me remains disturbed. I thought of the many retail investors out there who, spooked by the markets and assuaged by their bankers and advisors, switch out of their equity investments into safer instruments like bonds.

In doing so, they would have violated the cardinal sin of investing. They would have bought high (previously) and sold low (now). In purchasing yet another asset, they would have been buying at a high (assuming that a ‘safe’ asset would be one that is performing at this very moment) and who knows what the price would be when they want to sell.

Buying high and selling low seems like a surefire way to financial ruin.

It could have been stocks, it could have been unit trusts investing in a particular sector or a specific region, it could even be currencies and commodities like gold and oil. When there is weakness, we tend to sell out and run for the hills. When an asset becomes ‘risky’, we succumb and migrate to something safer. It has happened to me before and I am sure many out there can also relate.

Risk Aversion

In financial parlance, the term is called ‘risk aversion’. It means nothing more than how human investors try to avoid risk whenever we can. If we cannot avoid it totally, we try to minimise it. Risk avoidance comes easy. Instinctive even.

On top of that, we also need to understand that different people have different levels of risk. Some can only sleep if the money is underneath their pillows. Other crave of the volatility of market movements and stay awake all night staring at the screens waiting for the big move.

People with different risk levels should invest in different things. In order to capture these differences, banks and financial institutions come up with profiling questionnaire and tools. After determining their risk appetite, the institutions will channel investors towards appropriate instruments.

 

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A portfolio based largely on bonds would be built for the conservative investor. Stocks tend to be more suited for an investor seeking higher returns and be willing to take more risk. For the gung-ho investor, there is always exotic instruments and leveraged products.

State vs Trait

Psychologists make a clear distinction between a state and a trait. Personality traits are stable characteristics of an individual. Traits are likely to see very little variation over the lifetime of a person. For example, someone who is outgoing and friendly will tend to remain that way throughout his or her life.

A state, on the other hand, is a temporary change in one’s circumstances. It tends to be trigger driven. Someone who is angry or fearful tend to be so for a short while. And then it goes away and they go back to their outgoing and friendly self once again.
baby angerHunger is a state. It is temporary. When we are hungry, we eat to reduce our hunger. Cold is also a state. It goes away after we put on more clothes or turn up the temperature. Anger is also a state. It goes away when offending parties apologize, else it goes away with time.

Here is where the real issue with personality risk profiling kicks in. In completing the questionnaire, banks assume that people’s tolerance is a trait. They failed to take into consideration that it is also very much affected by the state of the investor.

It is the same when we are on our own. When we evaluate our own investment risk appetite coldly, we tend to evaluate ourselves based on our traits – ‘I am a young, I have a long horizon, I am relatively risk tolerant. I can afford to take more risk with my investments’.

We fail to take into account that risk tolerance is also a state. When we feel threatened, we reduce our level of risk to feel safer.

We all fail to take into consideration how we would feel when the markets tank. During the best of times, it is easy to imagine that we can stomach a 30% loss in our portfolios. When the market is in turmoil like now, the 30% seems like only the beginning. It is the thought of the markets continuing to tank that is driving our emotions. At times like these, we want to do nothing but reduce risk.

Investing in Stocks. 

During the 2008 crisis, the Dow went from 14000 to 6600, a decline of more than 50%. The STI told a similar story as it went from 3800 to 1400.

Stock investors should bear in mind that in the worst of a bear market, markets can and will drop by 50%. What this means is that if you are not comfortable with losing up to half your capital, you have no business investing in the stock markets. You would have suffered less pain and more gain if you had invested your money elsewhere.

A final word about risk. 

In reality, investors’ risk levels are never stable. They are event driven and they tend to fluctuate according to market conditions. Understanding this principle, there are two things at our level that we can do.

1. Determine our risk level accurately. Do not over-estimate what we can stomach. If we do, it will cause us to sell out when it is most painful and that is when the markets are at their lowest.

2. Understand that out tolerance for risk is a state and it is event driven. It will fluctuate. We need to keep them in check all the time. The narrower a band we can keep them, the better. It is the equivalent of not over-eating when we are hungry and not continuing to stuff our faces when we are already full.

These turbulent times are best for calibrating if you have gotten your risk appetite right from the very beginning. If you have, congratulations. If you have not, a valuable lesson awaits!

image credit: activistpost



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2 Comments
  • The Best Time To Start Investing
    Posted at 14:19h, 22 February Reply

    […] written articles about the market downturn. I tried to explain from a psychological point of view why investors sell out during market crashes, while Alvin shared an excerpt of a newsletter we send to our Value Investing Club […]

  • Are You Making These Six Common Investing Mistakes?
    Posted at 10:46h, 16 October Reply

    […] many end up investing when prices are high (feels safe) and selling when the market drops (due to […]

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