Thursday, 26 June 2008

Figuring Out How Risky to Make Your Portfolio - Ignorance is No Excuse

One of my pet peeves with those risk preference questionnaires from financial companies is the notion that a person's reaction to the possibility of a more or less large temporary dip in the value of a portfolio justifies a more or less heavy asset allocation to cash, bonds or equities. e.g. see the "Comfort Levels" portion of this typical questionnaire at Edmond Financial Group.

That's like your lawyer telling you to ignore laws because you dislike them.

It is true that if a dip makes you react and sell out at a market bottom then it is bad news. To continue the analogy, you went too fast in your car, had a crash, got a big fine, and now swear never to drive again. Does that makes sense? The problem is not the car or the law, but you and the poor behaviour.

In fact, it is too true that a majority of individual investors buy high and sell low, under-performing their mutual funds by a large margin. e.g. Cause of Low Returns for 401k Plan Participants on the IFA Canada website and The Sad Reality of Mutual Funds at InvestmentU.

Behavioural finance is the study of people making stupid money and investment decisions. It describes how people actually behave, not as they should do.

"... even if behavioral finance describes how investors actually do behave, it may not describe how they should behave. That is, investors may abandon their behavioral biases once they have the benefit of financial education and financial planning advice." John Y. Campbell and Luis M. Viceira in Strategic Asset Allocation Portfolio Choice for Long-Term Investors.

I'm all for that solution - investment knowledge and education. Once the risk-reward relationships of various types of investments are clear and especially the difference between short- and long-term investment returns of equities vs other asset classes, most people can modify their behaviour to match their real capability to bear risk, and their time horizon and investing goals (the other parts of those risk questionnaires). This is particularly important for long term goals like retirement, where the only hope of generating a large enough sum is to have a healthy dose of equities. Ignorance should not be an acceptable excuse.

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