Two books that I recently read are “The Undoing Project” by Michael Lewis, and “Nudge” by Richard Thaler and Cass Sunstein. Both books are about the broad field of Behavioral Economics, or what economic choices people make and how they make them. “The Undoing Project” is a semi-biography of the founders of the field of Behavioral Economics, two Israeli economists/Ph.D.’s named Amos Tversky and Daniel Kahneman. Tversky and Kahneman both taught extensively in the United States, and Thaler and Sunstein studied under them and are their disciples. I am not a proponent of Sunstein’s politics, but the book was very interesting.
Both books stated that individuals are not very self-aware and that they make poor economic (and other life-related) choices as a result. Individuals are not objective when it comes to themselves, and they often need a third-party objective eye to help them make better personal decisions. A lot of research and some pretty humorous experiments resulted in these conclusions. Think about it – Do you honestly think you make the best decisions about yourself? Or does it help if you talk it over with friends, relatives, spouses, experts, people you trust, and the like? Don’t you really make better decisions if you have outside, more objective help? I think I do. Probably you do, as well.
One of the standard steps that occur when a financial planner engages with a client is to have the client fill out a risk tolerance profile. Perhaps the planner fills out the profile while speaking with the client, but the result is similar: The client tells the planner what they feel their risk tolerance is. A lot of extensive brainpower and research has gone into compiling these risk profile questionnaires.
How reliable are these risk profile self-assessments? Tversky and Kahneman, as well as Thaler and Sunstein, would say Not Very. People don’t make good decisions about their own lot in life, they all would say. For years, sentiment among financial planners has been that people think they are risk tolerant when markets are strong, and not as risk tolerant when markets are weak. Texas Tech University researchers Michael Guillemette and Michael Fink have researched this phenomenon, and they have presented the following chart, which graphs surveyed risk tolerance vs. the S&P 500:
The information is now a few years dated, but the point is still valid: Risk tolerance ebbs and flows with the S&P 500, not perfectly, but pretty well correlated. People feel they are more risk tolerant when the market is good, and not so when the market is bad. Ergo, in a macro sense, you can’t trust yourself to determine your own risk tolerance.
Mike Tyson famously said, “Everyone has a plan until they get punched in the mouth.” A financial punch in the mouth is a major market correction, a la 2008, which is displayed in this chart. Once you get a big punch in the mouth such as 2008, you become shy, and a smaller punch in the mouth hurts maybe more. The best way to “roll with the punches” is to have a well-diversified portfolio. When I say “well-diversified”, I mean among different asset classes – equities, government bonds, corporate bonds, hard assets, and cash. Also, trust me when I say you shouldn’t trust yourself to determine how tolerant you are of risk. In fact, you will find out for yourself during the next correction, when you get your account statement and your worth has deteriorated. If you are well-diversified, the punch in the mouth should not hurt as much. A final shameless plug: Work with a trusted financial advisor and allow them to understand that your own risk tolerance assessment is a point to be considered, but not the final statement about the composition of your portfolio.