American economist, Heyman Minsky, famously observed that it is impossible to design a crisis-proof financial system. Although investors are generally aware of the risks and rewards of equity investments, nobody wants to lose money in financial markets, therefore, investing in turbulent markets can be very disconcerting.
In periods of extreme market stress, the predominant advice to clients is to stay invested. Selling out of the market during these times tends to be detrimental to the long-term goals of clients. In most cases, staying the course is the most prudent option. However, some clients ask whether this could be the time to buy more equities since prices are heavily depressed. The answer will depend on a client’s risk capacity (the ability to endure investment losses), and ultimately, risk profile (the factors that help shape risk-taking behaviour). Risk capacity and risk profiles vary from client to client, therefore, the decision to buy more equity investments during these times should only be taken after considering these factors.
For an investor with a low-risk capacity, a huge drop in the markets leads to an even lower risk capacity. An investor with a high-risk capacity, on the other hand, faces a different situation. A decline in market values leads to a higher risk capacity. If the decline is severe enough, the risk profile may significantly change and could warrant a portfolio change. Risk capacity has a multiplier effect on risk tolerance. If the client’s risk capacity remains neutral after a severe drop in market prices, the risk profile will match risk tolerance. However, subject to certain behavioural constraints, if risk capacity significantly shifts above neutral, the risk profile moves up as well, while a significant shift in risk capacity below neutral leads to a downward shift in risk profile.
Although there are theories about the relationship between risk and expected return, there is no theory on the levels of risk one should find in the marketplace, therefore, we cannot determine a “natural” level of risk. We can only estimate from historical data the levels of risk investors are likely to confront. Furthermore, determining an appropriate risk capacity and risk profile is not an exact science, but there are different tools and techniques available to help advisors determine a suitable risk profile for clients.
During periods of markets stress, the role of the financial advisor as a behavioural coach becomes overly critical in helping the client stay on track to achieve their financial goals. This is the time for the advisor to be on the lookout for behavioural risk attitudes – the unstable, short-term behavioural readiness to take a risk. This is different from risk tolerance, which is a reasoned disposition to take a risk in the long term. Behavioural risk attitudes are context-dependent and transient and can have negative effects on long-term goals if they are misconstrued to be a guide to long-term risk preferences. Behavioural risk attitudes include loss aversion, probability distortion and ambiguity aversion. In addition to being unstable, behavioural risk attitudes generally result in irrational levels of risk aversion.
When there is severe market stress, the investor is faced with three lines of action:
Sell out of the market to avoid further losses;
Buy into the market to take advantage of the depressed/cheap prices (buy low); or