What’s your risk tolerance? How do you indentify it? Both are important questions that investors spend little time thinking about at first. They’re also abstract questions thanks to the convoluted definitions of risk.
Daniel Kahneman suggests a better way to frame the question. Rather than risk tolerance, you should ask: what’s your loss tolerance? It makes you think about protecting your money. How much loss can you endure before you reach the point where emotions push you to change your mind and change your portfolio?
That breaking point is important because it’s usually where mistakes are made like buying high and selling low. Changing your portfolio every time emotions surface leads to worse results.
By reframing the question, Kahneman forces you to think in terms of actual dollars. Lost dollars can be quickly equated to missed goals and dreams — less money for college, a canceled vacation, a postponed retirement — that make you nauseous.
So how much of your net worth do you want to keep safe versus how much are you willing to lose outright? The goal is to find that breaking point so you can build a portfolio that minimizes regret, limits how often you change your portfolio, and keeps you invested for the long run.
Kahneman went on to explain the importance of minimizing regret and how it translates to portfolio construction. Here’s what he said:
Kahneman: Our thinking on this was that the issue is not so much tolerance for risk as it is tolerance for losses. Tolerance for losses means that you have to know — the individual investor has to know and certainly the advisor has to try to know — how much loss the person will be able to tolerate before he changes his mind about what he is doing. Clearly, changing course by and large is not a good idea, and selling low and buying high is not a good idea. You have to anticipate regret and identify the individuals who are very prone to regret. They’re not going to be very good clients for the financial advisor. If people are very prone to regret, then you have to help them devise a plan that will minimize their regret. For the very wealthy, emotion is clearly important in determining what policy is appropriate…
The main question that I found useful to ask when someone is very wealthy is how much loss is the individual willing to tolerate? That is, what fraction of their wealth are they actually willing to lose? It turns out that fraction is usually not very large. That’s a very important parameter. How much do they really want to protect as much as possible, and how much are they willing to consider losing? That varies a lot among individuals. By and large, the very wealthy mostly want to protect their wealth, and they’re willing to play with a small fraction of it. That is the fraction they are prepared to lose, but it’s not a large fraction. So they’re loss averse, not risk as such.
Q: So you’re suggesting that setting a stop-loss higher or lower depends on your willingness to accept a loss? Is that a good approach?
Kahneman: For the individual who is very concerned about losses, I think this is certainly a good approach. That’s the major question you want to ask the investor. How much are willing to lose? Then you have to take steps so that they won’t lose more than they are willing to lose. That’s in effect a stop-loss policy.
Q: Could you in fact organize questions that involve costs of insurance to see how much they’d be willing to pay for insurance that would protect against losses?
Kahneman: That’s interesting. I hadn’t thought of it that way — in terms of insurance. Yes, that would be an interesting approach. Also, people have to become aware of the fact that by stopping their losses, they are giving up some potential upside. Looking at the trade-off between the upside and the downside gives you a sense of their attitude toward losses and what you should encourage them to do.
Q: You mention that people are willing to play with or lose some portion of their money. I don’t know if you have in mind that they keep two mental accounts: one is money that is not to be lost, and the other is money that can possibly be lost?
Kahneman: That is exactly what we have in mind. We actually had the individual construct two portfolios. One is a portfolio that is designed mainly for safety, and the other portfolio is designed to take advantage of opportunities. The relative size of the two portfolios represents one way of identifying loss aversion because with your riskier portfolio, that’s an amount you can consider losing. It’s not only two mental accounts. At least with some clients, we make this completely explicit, that is, clients receive information about two accounts, about their safe account and their riskier account. This is a very natural way for people to think.
This post was originally published on July 31, 2019.
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