The science behind accurately assessing your tolerance for investment risk
When it comes to investments, at Church House, we consider the management of risk to be our primary function. Notice I didn’t say the elimination of risk. If we want a return, we have to have its uncertain counterpart. Managing this risk a huge responsibility. We want to ensure that we deliver the returns you desire, without the shocks you fear. So, how do we know that we are taking the right level of risk for you, our client? Well, to put it plainly, we ask you.
But how reliable are you at knowing how much risk to take? How much risk you can afford to take? How much risk you are comfortable to take?
In a recent blog, Greg Davies, behavioural finance expert at Oxford Risk, one of our risk assessment partners, suggests that we are perhaps not very good at assessing these factors for ourselves.
Greg alludes to us having at least two attitudes to risk. Our willingness to take risk in the long term and our willingness to take risk today. As human beings, we tend to place too much emphasis on recent events, a phenomenon known as recency bias. But how important is what’s happening today, or last year or even next year to the long term investment strategy for our pension and other investments? Arguably, not at all.
Recency bias isn’t the only behavioural bias we have to contend with when we are making decisions about our investments. Another potentially detrimental behaviour is called the emotional gap. This is our tendency to make decisions based on extreme emotions, such as anger or sadness, rather than waiting until we are in a less emotional state and probably better able to make a rational decision. By acting on extreme emotions, we might take risks that are inappropriate to our long term strategy, or we might avoid taking a risk which would be sensible and supportive of our overall investment aims.
Another behavioural bias worthy of mention in the context of investments and risk assessment is loss aversion. We “feel” losses far more than gains and will take great pains to avoid losses, even if the risk associated with that particular investment, if considered rationally, is absolutely appropriate.
So, how do we “manage” these and other behavioural biases to ensure we make rational decisions? At Church House, for our bespoke portfolios, we use sophisticated risk modelling software, developed by Oxford Risk. This questionnaire asks a number of questions and is designed to help you see through your emotional and behavioural biases to reach a rational position. This enables us to find an investment portfolio which meets your requirements for growth and allows you to sleep at night knowing that we are not taking unnecessary chances with your investments.
Appointing a trusted adviser to manage your portfolio on your behalf within agreed parameters helps you to avoid some of these behaviours, because you are not making those investment decisions on a day to day basis. You’re leaving those decisions to us.
The contents of this article are for information purposes only and do not constitute advice or a personal recommendation. Investors are advised to seek professional advice before entering into any investment decisions. Please also note the value of investments and the income you get from them may fall as well as rise and there is no certainty that you will get back the amount of your original investment. You should also be aware that past performance may not be a reliable guide to future performance.