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Investment Strategy
Tuesday, April 1, 2008
Know Thyself

“Know thyself”. According to the Greek writer Pausanias (who lived around 2 A.D) this aphorism* was inscribed in the forecourt of the Temple of Apollo at Delphi. As this temple was built somewhere around 1,500 B.C., we can assume that the phrase had been around a long time before that.

Like many philosophical thoughts this principle can be applied to many different aspects of peoples’ lives — including investing.
People are unique. I doubt that’s a new aphorism, but we’ll plug on nonetheless. People are unique and each person brings their own mental ‘baggage’ to the process of investing. I refer to it as ‘baggage’ because it comprises a collection of thoughts, prejudices, ignorances, fears, hopes and ideas which are there to create unique impediments to ‘rational investing’.
The investment game is one which carries on over a long period of time. The game has rules and outcomes, and more than one road to the various destinations it can reach. To keep investors playing the game to the (optimal?) conclusion, the investors need to know themselves and, in particular, know what their tolerance is for risk.
“Risk Tolerance can be defined as the degree of uncertainty that an investor can handle in regard to a negative change in the value of his or her portfolio,” according to Investopedia.com. Risk tolerance is thus a purely psychological state of mind. On the other hand, ‘Risk Capacity’ can be defined as “the amount of money an investor could afford to lose, without putting the achievement of his investment goals at risk” (Davey, Geoff A Micro-Behavioural Finance Case Study, 2004). An investor’s risk capacity is an objectively quantifiable sum.
Market volatility inevitably proves to be fantastically accurate in revealing investors who have been exposed to investments inconsistent with their tolerance for risk. Most of us should be familiar with that old quotation from Warren Buffett which says that “you can only find out who is swimming naked when the tide goes out.” What he was saying was that investors who are overexposed (to risk), are revealed when the markets pull back.
And pull back the markets did since October last year, and the overexposed clients all started to cry and this led, in some instances, to nervous investors fleeing investments which they should never have been in in the first place at a time when the value of the investments was well down from their 2007 highs and they thus incurred losses.
The investors who had been positioned in appropriate investments for their risk tolerance (properly diversified across the domestic asset classes as well as the vital offshore component) were not naked when the tide went out. They had the mental tolerance for risk which allowed them to be sufficiently patient to know that the tide would come back in again and maintain their investment courses. By not selling out of investments as they bottomed-out, they will ride the volatility back to the levels where the value of their investments will exceed their 2007 levels in time.
An investor who does not know his risk tolerance has no way of knowing whether or not he is swimming naked. He runs the risk of exposing himself to more volatility than he can tolerate and the real chance of incurring investment losses at the worst possible time. An advisor who does not know his client’s risk tolerance runs the risk of losing his client as he or she gives flight from an inappropriate investment plan.
Know thyself, and know thy client. Adopting a financial plan which is appropriate for both the client’s risk tolerance and risk capacity will lead to long-term happiness and investment success. By Mark Cliff of Alphen Asset Management
 

Copyright © Insurance Times and Investments® Vol:21.3 1st April, 2008
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