In Nick Bullman’s world, the efficient market is a myth and the rational investor is but a theory.
Bullman, founder of CheckRisk, a UK-based risk assessment and reporting firm, says just when a rational person would be taking a higher level of investment risk, many investors are at their most risk-averse.
And vice versa – when a rational investor would be running for safety, many people are taking on far too much risk.
Bullman, who is a keynote presenter at this week’s Portfolio Construction Forum Conference 2012 in Sydney, says an individual’s tolerance for risk can be divided into two parts. One is essentially a psychological ability to tolerate risk, and the other is a physical ability to sustain risk.
For example, an investor might have $100 million of assets and easily be able to sustain a $1-million loss, but will stay up at nights worried sick about that prospect. On the other hand, they might have $1 million in assets and be physically incapable of sustaining a $1-million loss (it would wipe them out), yet not be at all worried by that prospect.
“One’s capacity to tolerate risk and one’s financial ability to sustain it may be two different things,” Bullman says.
“These are factors that are related to the individual. But then there are macroeconomic factors and they are exogenous.”
Most often it is when an individual’s “inherent” risk tolerance, as it were, clashes with the quantifiable level of risk in investment markets that investors come undone.
This explains why investors behave as if bull markets will never end, and why they also behave as if economic crises will never be resolved.
Bullman’s insight is to overlay the exogenous risk factors (reflected in the risk that exists in investment markets) with the individual’s risk tolerance, and to identify those moments when an individual’s inherent risk tolerance is likely to get him into trouble. For example, when an investor continues taking too great a risk in a market that is clearly overvalued.
Homo economus rethought
Bullman says the concept of the rational investor – Homo economus – is “all well and good when you are in bull markets and everything is fine”.
“But when things become more volatile, people become irrational,” he says.
There are two things a good adviser can do to help protect clients from themselves.
“The first thing is to persuade clients to take a long-term view,” Bullman says.
“The second thing is to be very efficient in your assessment of the client’s risk appetite, and that’s quite difficult to do.
“Clients often become less risk tolerant at a time when they should be taking more risk and become more risk tolerant at a time when they should be taking less risk.
“In the volatile market that we’ve had since 2008, you may have been categorised as a high-risk-tolerant person, but did you want to be taking a high level of risk at that time?”
Bullman says advisers should reassess clients’ risk tolerances regularly – at least every six months, and preferably quarterly – to make sure they’re not taking too much risk for the likely reward they will get or, conversely, to make sure they are taking enough risk at the right time to achieve their investment objectives.
“Are they being paid to take a risk at a specific point in time?” Bullman says.
“There are times when you are a low-risk person but you should become more risk tolerant.
“It’s very, very counterintuitive at that point. People will have seen a market falling, and they will not be able to make the right risk assessment… and they are unwilling to commit themselves to the long term and to value.
“Why? Because it’s very scary.”
Bullman says that in psychological terms, investment losses trigger a response in the same part of the brain that reacts to the fear of death. Conversely, investment gains trigger a response in that part which also responds to food and sex.
“That’s why we chase gains, but can be overfearful of losses,” he says
