Diana Clement: Risk aversion not always good for investors

A 'glass half-empty' stance reaps fewer rewards. Photo / Thinkstock

Risk aversion is good. It can prevent you from making huge mistakes in life and with your investments.

Yet it holds many investors back from achieving what they want financially.

Risk-averse investors have a really sorry lot in today's economic climate. They lose ground financially while the cost of living skyrockets.

Returns on fixed-interest investments are pathetic and inflation is eating away what there is.

Some of the problem is that many people fail to overcome their pre-programmed loss-aversion.

That loss-aversion bias in the human mind leads us to put more weight on prospective losses than gains, according to behavioural economist Daniel Kahneman.

Risk-averse people often fail to understand the difference between risk and volatility. They react to changes in value on paper, failing to realise they haven't "lost" any money, says Robert Oddy, of International Financial Planners.

So losing $50,000 of investments causes them greater anxiety than the equivalent psychological boost from gaining $50,000. And if a person "loses" $50,000 because of a market fall and then the investment recovers to the original position, he or she does not feel satisfied.

Consequently people make less than optimal decisions to avoid loss.

Ironically, those decisions can lead to the exact losses they were trying to avoid in the first place.

I hate to bang on about the finance companies and the likes of the Blue Chip and Merlot property "investment" firms. Investments with these companies were classic examples of risk-aversion gone wrong. Conservative investors in their thousands believed they were taking the safe option and avoiding the "risk" of investing in shares.

Another example of where individuals don't understand the risk they're taking, says Oddy, is those who invest in shares of the company they work for.

The individuals rely on their employer for their income and then invest their capital in the same firm. If the company goes bust, they lose their job, their investment and possibly even their home if they can't afford to keep paying the mortgage.

One problem with a topic such as this is that typically people who are excessively risk-averse have no idea they are, and those who shouldn't be taking more risk read an article like this and launch into an investment with unacceptably high risk.

Those who leap on the latest bandwagon may fail to realise that they're taking a risk. And what one person sees as risky could be a very tame investment to the next.

It's fine to be risk-averse if you accept the outcome will be reduced financial resources later in life. You're not going to have your current lack of retirement portfolio turned around if you're not willing to take some risks.

The antidote to risk-aversion is education. There are some really useful tips for people in this category who don't want to be hamstrung by their natural risk-averseness:

1. Understand your own risk-tolerance. Get your financial adviser to use a professional risk tolerance test (which should be much more than a one-page questionnaire). DIY investors can do their own at Myriskprofile.com.

2. Look at the types of investments/portfolios recommended for people with your risk tolerance.

3. Look at low-risk ways to start investing in higher-growth investments - such as drip feeding your money in bit by bit.

4. Get a book out and learn about how markets work. Something you understand is a lot less frightening than something that you don't.

A survey by United States fund provider Vanguard this year found that the biggest group of people were willing to take average risk for average gain. About 7 per cent of Gen Y and Gen X people and 4 per cent of baby-boomers were willing to take substantial risk for substantial gain. At the other end of the scale 9 per cent of Gen Y, 6 per cent of Gen X and 8 per cent of baby-boomers were unwilling to take any risk.

There isn't a problem with any of these provided your expected outcome matches your risk profile. In other words, those only willing to take average risk are fine provided they're only expecting average gain.

The thing is, younger people can afford to take more investment risk than older people. That's because they have smaller pots of investment capital and their greatest financial risk lies in losing their income, not capital. Risk is a chance for younger people to make the most of capital growth that markets afford them.

Taking too much risk at any age can backfire. A 30-year-old whose portfolio halved in 2008, or who built up two or three investment properties and lost them after being made redundant, might never ever take risk again, to the detriment of his or her retirement savings.

Generally, says Oddy, his clients are educated to understand portfolios will rise and fall over time and factors such as the dollar's value can affect apparent performance.

But he does see clients suffer angst when they read news headlines that make them fearful, or hear the opinions of neighbours and colleagues who may not necessarily have more financial knowledge.

Generally, individuals are actually not too bad at estimating their own risk-tolerance, says FinaMetrica's Nicki Potts. They are more accurate than their advisers at guessing risk-tolerance, says Potts.

Even if they know their own risk-tolerance, people don't always invest according to that tolerance. They use other biases, or a complete lack of understanding of the risks involved in investments to choose their portfolio.

There are also very different perceptions of risk. What's riskier? To put $100,000 in a savings account earning an average of 3 per cent over 10 years, but being eaten away by inflation, or to choose a basket of shares returning 6 per cent, but fluctuating in value wildly over 10 years?

Should the value of that share drop by a third part way through the 10 years, but recover and grow to exceed the savings account by the end, the investor may still be unhappy with the outcome.

Risk-aversion is really asserting itself with KiwiSaver, where people's retirement funds are invested in conservative funds unless they make an active decision otherwise. Plenty of these funds won't beat inflation, and hence not provide much in the way of a nest egg.

Morningstar, which does an annual performance survey, found that the returns over the past two years were greater the further up the risk scale you went, with the conservative KiwiSaver funds averaging 6.95 per cent a year compared with 9.95 per cent a year for moderate funds and 14.16 per cent for aggressive funds.

Two years of data isn't sufficient to make meaningful comparisons and it will take more time for the differences between the fund styles to become truly apparent. By the time they do, many KiwiSavers may rue their conservative choices.

The other big financial investment for most Kiwis is their day job. Being too risk-averse in job hunting and career planning can be a real financial handicap.

Certainly some people climb the greasy pole in one company. But it's more common to increase salary by taking a risk and jumping ship to a new organisation from time to time.

Likewise the risks of being an entrepreneur are greater than the risks of staying put in a stable job.

Many a potential entrepreneur has, because of risk-averseness, never taken the leap. Nor might they have succeeded. Yet they weren't willing to try. Only those who could overcome their risk-averseness ever succeeded.

Yet the returns from making that leap can be very large indeed. Get the equation right and a lifetime of saving can be eclipsed by business returns in a few short years.

Being less risk-averse doesn't mean having to make your own decisions. You can be less risk-averse and use an adviser.

That may be a financial adviser. It could be a career adviser.