Don’t let overconfidence define your risk profile
Financial advisers spend a lot of time trying to understand a client’s risk profile. They often employ questionnaires that ask myriad questions to try and pinpoint the time period of an investment, investment knowledge and how one would react in various market scenarios.
The problem with these questionnaires is that they only paint a picture based on current trends.
What do I mean by current trends? In an interview last year with Morgan Housel of the Motley Fool, Israeli Nobel laureate Daniel Kahneman explained this concept. “The decision-making process is basically inferring from recent trends as if they were to continue,” he said. “That seems to be the information that people go on, and so when things have been getting worse for a while, you become pessimistic, and when things have been getting better for a while, you become optimistic, and it’s those feelings that really control the investment, I think.”
This is a behavioral economist’s dream. And while I have many points of contention with the behavioral economists, I think they are spot on with this topic.
Confidence
Upon completing university, I moved to Israel and I was a struggling new immigrant, cleaning toilets to pay the rent, I needed to purchase an airline ticket to fly back to the U.S. I was a big fan of trading options — an aggressive investment approach — and had some success. So I decided to trade options for a short period of time and make enough money to purchase a ticket and then some. Lo and behold I succeeded, and I was off to the U.S. Then I got overconfident and started trading options at a furious clip, and within two weeks I was once again a struggling new immigrant cleaning toilets. My own overconfidence led me to dismiss various risks and created a sense of stock-trading invincibility.
In referencing researcher Terrence Odean’s 1998 study entitled “Volume, Volatility, Price, and Profit When All Traders Are Above Average,” Albert Phung wrote, “overconfident investors generally conduct more trades than their less-confident counterparts. Odean found that overconfident investors/traders tend to believe they are better than others at choosing the best stocks and best times to enter/exit a position. Unfortunately, Odean also found that traders that conducted the most trades tended, on average, to receive significantly lower yields than the market.”
Skewed perception
It’s our short-term memory that skews our perception. My hunch is that if you give an investor a risk-profile questionnaire to fill out in the midst of a bull market and then give another one during or after a market fall, you will end up getting different responses.
I recently opened an account for a client who insisted that he was a long-term investor. He was a big believer in emerging markets and decided to put all his money in exchange-traded funds (ETFs) that track various geographical regions in Asia and Latin America.
About six weeks into his investment he called with a panicked tone. He said he wanted to sell out of his investments because they had dropped 6% on average. I reminded him of his insistence six weeks earlier that he was a long-term investor. He said the drop scared him and he believed the market is going to crash, and he wanted only the most conservative investments.
It isn’t just my client. Many investors have a large appetite for risk when things are going well. When markets aren’t so kind, they are the first to run for the exits.
What should you do?
As I have written many times, investors should focus on achieving their goals, not trying to make as much money as possible in the market. Money should be used for specific purposes — not to die with the most money possible. The one who dies with the most money does not win.
Take out a pen and paper and prioritize your short- and long-term goals and needs. Then create a portfolio that will enable you to achieve what is truly important to you.
