Basic risk management
What is risk management? Fundamentally, it is a way of lessening the impact of the unexpected. As we explain in this article, the first step is to identify the risk(s). Depending on the investment, the risk could be a regulator, the broader market, or a specific counterparty. Then it is a question of monitoring, measuring, and implementing measures to mitigate the adverse event should it transpire.
Insurance, cash reserves, and hedging (e.g. against currency fluctuations) are common approaches used in the world of finance, and a good manager will use an appropriate mix to guard a portfolio’s returns. Diversification and reducing concentration are also critical tools in risk management, as they can minimize the impact of correlated risks.
The emotional dimension
However, the greatest risk an investor faces is not an external one, but the investor’s own psychology.
The clearest illustration of this is the DALBAR study, which shows the difference between average market returns and the average returns to an investor in the market.[1]
The message of this study over the years is clear: investors significantly underperform the market benchmark, sacrificing millions of dollars in returns over the course of a career.[2] In other words, it is the behavior of the investor, not the market, that is the problem.
Why is this the case, when an investor could match the market return simply by doing nothing? As we all know, emotions such as greed and fear lead people to over-invest in some areas and sell out too soon in others. In the process, they can upset their financial goals and act as their own worst enemy.
Hedging against bias
Managing psychology, or behavioral risk, is no different from any other form of risk management. However, the first step - identifying that the risk is there - very often does not take place. This is why it is so dangerous.
In recent years, behavioral psychologists have identified many systematic biases (e.g. narrative fallacy, loss aversion) that cause investors to act against their own interests.[3] A properly trained financial professional will be aware of these biases and can plan accordingly.
It is beyond the scope of this article to examine all the biases and ‘behavioral hedges’ that investors can use to counter them. But here is an illustrative example.
Psychological ballast
In 2022, the S&P 500 Index plunged by 19%. This double-digit decline, which followed a 10-year bull run (broken only by the pandemic shock), was highly disconcerting for investors. The following year, the index rose by 24%, essentially erasing the loss of the previous period, and making investors whole again.[4]
Of course, only those investors who held on were made whole! Those who sold amid the panic locked in their losses and missed out on the upside as - for example - leading stocks like Meta soared back up to surpass previous all-time highs.
Meta Platforms Inc. stock price (Source: Wall Street Journal)
Gold is known to be a countercyclical asset. During the panic of 2022, it remained firm while the market fell, and in 2023 gained 13%. While the impact of this may have been limited in purely financial terms (gold is typically less than 10% of an investor’s portfolio), the psychological effect was significant. Investors with an exposure to gold could feel that their portfolio was anchored rather than adrift during the chaos of 2022, so lessening the chances of panic-selling.
Irrational? Maybe. But emotions very often are irrational, and require corresponding solutions. Disciplined asset allocation and diversification into other assets, such as private equity with historically lower drawdowns, can help limit the downside.
Conclusion
In general terms, having clear goals against which to measure progress, scheduling automatic contributions & rebalancing, and holding regular review meetings will all tend to keep your portfolio on its intended path.
However, different investors are more or less prone to various biases. Identifying these biases and mitigating them is best done with an advisor who can offer an objective assessment of the former and an informed strategy for the latter.
[1] Morningstar
[2] Forbes
[3] Corporate Finance Institute
[4] Nasdaq