Portfolio Ideas: Fearing risk, yet taking risk too

As investors we have a multiple risk personality and are more loss-averse

Are you really risk averse when it comes to taking financial decisions? In this article, we discuss why you, just like most of us, avoid risk when you should take some, and take high risk when you should not!

Multiple risk-personality?

Quite contrary to what we would like to believe, we are both risk seeking and risk averse. That is, we have multiple risk personality.

Take your investment portfolio. You are comfortable with bank deposits, real estate and gold, but not with equity. Why? The certainty in cash flows makes you feel safe with bank deposits. Unlike stocks, real estate is not traded on the exchange. The lack of visible prices gives you the illusion that real estate prices are stable, if not rising.

As for gold, you consider it as a consumption asset meant for personal jewellery when prices go down, and as investment when prices move up! So, decline in gold prices does not cause regret and pain.

Clearly, equity does not fit within your risk-averse universe. The reason is simple. Why invest in risky assets such as equity and regret the decision, especially when you have steady active income, non-visible real estate prices and fixed interest income?

But it is exactly when your income is steady that you should be investing in equity! This is because you should balance your income stability with your portfolio volatility. So, when you have steady income, your investment portfolio should have more proportion of equity than bank deposits. And when your income level is unstable, your portfolio should have more bank deposits than equity. And yet most of us do exactly the opposite!

Consider an individual who faces a salary cut or a job loss. This individual is more likely to take higher risk such as start a business that she has been postponing for a long time. The logic? Having already lost a job, the argument is that the downside in income is limited! But the risk capital for the business will come from redeeming existing bank deposits. And that could hurt the individual’s investment capital too!

So, what makes you take risky decisions in certain situations and not in others? The answer lies in a behavioural bias called loss aversion. That is, you are not really risk averse.

You are loss averse.

When faced with losses, you embrace risk to avoid further losses, or to prevent yourself from realising existing losses. So, an individual starts a business when she loses her job to avoid loss of existing standard of living. Or you refuse to sell a stock when it is below your purchase price because you want to avoid realising losses. And these are exactly the situations when you should not take further risks!

Moderating loss-aversion

It is difficult to moderate loss aversion bias. Why? When you are fixated on taking risk, it is highly unlikely that anyone can stop you! That said, if you are married, you should consult your spouse and take a joint decision regarding the issue at hand. Often, your spouse will have a conservative idea if you have an adrenalin rush! Or you could have an investment advisor helping you as a behavioural coach nudging you into taking optimal decisions.

Finally, if you are struggling to take stop loss on your trading portfolio because you are loss averse, you should ask your friend to execute stop loss on your trades! And likewise, you should execute stop loss for your friend’s trading account, for, .emotions play a minimal role when executing stop-loss rules for others!

So, the upshot is this: You are not always conservative in taking financial decisions. The pain or the regret you experience from an outcome can drive you from risk-seeking mode to risk-averse mode. That is why you buy insurance products and yet often gamble with critical financial choices!

The writer is the founder of Navera Consulting. Send your feedback to portfolioideas@thehindu.co.in

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