Calculate Risk And Then Invest

My concept of risk changed after I read a personal narration by Jason Apollo Voss, author, and CEO of Deception And Truth Analysis Inc (DATA).

His firm analyses scientific research on investment managers’ beliefs, vulnerability and skills at detecting deception, how long markets take to price deceptive behaviours, and how investment managers can combat deceptiveness on the part of companies.

Here’s What He Shared

His daughter went on a week-long, annual, river rafting and camping trip organised by her high school. Though it was spring, there was heavy snowfall the previous winter which resulted in exceptionally high river flows with fast rapids. To compound an already precarious situation, snowfall and freezing temperatures had been forecast that week.

Within the first hour, each of the rafts capsized in the river and the students were in danger of suffering from hypothermia. Most of the food and medical supplies were lost to the river, and thus were in extremely short supply. A student broke his leg. One of the instructors/guides essentially suffered a mental breakdown. Several students had to be hospitalised, with half of them becoming critically ill.

Naturally, the parents were in an uproar with the school’s administration and demanded an explanation as to why they had wantonly endangered the kids. They also demanded an explanation as to why the instructor-in-charge refused to call off the entire exercise and decided to persevere through the rest of the week. The school authorities informed the parents that the instructor was extremely experienced and had led many such expeditions for over a decade without incident.

Jason explained why the school administration engaged in an incorrect risk analysis of the instructor’s experience.

Wrong context: The relevant experience for the situation was NOT how many years of expeditions he had led.

Correct context: The relevant experience for the situation was how many expeditions he had led where everything went wrong.

Not just blanket experience, but relevant experience—experience pertinent to the situation. It turned out that the instructor had never really come anywhere close to experiencing these difficulties in the past.

When someone says they are intuitively good at selecting stocks, ask them over which market cycles. In a bull market, the tide carries the wise, the foolish, the naive and the stupid. The test is whether they have endured a bear market. A lot of the investors who have never experienced a market, such as 2008 or 2020, won’t know the amount of emotion a stock market drop can evoke. It is different reading about it, than experiencing one.

I used to always say that a drop in the market doesn’t frighten me. In fact, when the market fell, I would buy more. But that was during the days when I had a steady cash flow by way of a salary. Now that I don’t, I am not indifferent to a market correction, and it does make me uncomfortable. I am still the same person, but the context through which I view life has changed. Hence, my tolerance for risk has changed, even though I may still have the capacity to take risk.

Let’s Look At It Differently.

Take two 25-year-old women, Tina and Anita. Each live with parents and earn identical amounts of money. Same age, gender, earnings, marital status, and both reside in the same area.

Tina has it fairly easy as far as financial obligations go. No dependents, no debt, no rent. She can save a huge chunk of her salary. Anita does not have this luxury. Her parents are dependent on her and she runs the house with her income. She cannot afford to save much and has to allocate a substantial amount to a fixed deposit (FD) because of her parents’ medical needs.

Circumstances ensure that Tina has a high capacity for risk, while Anita has a low capacity for risk.

Both women are young and should invest in equity. Unfortunately, Tina is not comfortable investing in the market and the swings in the equity market since last year have frightened her. She prefers investing in gold, bank FDs, Employees’ Provident Fund (EPF) and Public Provident Fund (PPF). She has a low risk tolerance, though her risk capacity is high.

Anita is very comfortable with the ups and downs in the market and would love to invest most of her money there. She has a high risk tolerance, comparatively, even though her risk capacity is much lower than Tina.

Context Matters

Risk is an inherently complex concept, and when the subject crops up, you are entering the domain of subjectivity and emotion. This is why it should always be viewed in context.

When you have a psychological safety net (such as a comfortable corpus, good steady income, wealthy parents, huge emergency fund), your perception of risk alters, and you approach life differently.

I remember a friend’s son teasing him for being so conservative with his money. The father’s response: “If you invest and lose, you will feel bad. If I invest and lose, it’s not just me, but the entire family will bear the repercussions. You can afford to that risk, I can’t.” Same family, but the context through which the father and son view life differs, hence their perception and tolerance of risk.

When investing, pay heed to your risk tolerance and risk capacity, but let the latter lead the way. It stacks the deck in your favour.

Risk Tolerance

• Your inherent attitude towards making mistakes, type of personality, and comfort level with upheavals, determines the tolerance level. It is your psychological ability to handle loss and disruption. It basically relies on feelings, emotions, and comfort level. Too much reliance here will let your gut or impulse drive your decisions.

• Too much focus here means that you are essentially letting your gut and impulse drive your decision making. You may end up going overboard on equity, or be drastically underinvested.

• People overestimate their tolerance levels when the market is relatively good. And when it plunges, as it inevitably does, they realise that their tolerance was not as high as they perceived it to be.

Risk Capacity

This focuses on your actual ability to withstand losses. It tells you how much risk your finances can realistically absorb.

It depends on the practical and tangible aspects of life:

• Income

• Savings ability

• Investment corpus

• Dependents

• Expenses

• Time horizon to goals

By Larissa Fernand, Behavioural Finance Expert