Category Archives: Financial Risk Tolerance

A Market Correction in 2019?

September 2018

By John Grable, Ph.D.

What I am about to state is so obvious that it is difficult to put into words. Nonetheless, here is something every financial advisor needs to remember: the majority of clients and markets are average. Why is this important to remember now in the context of financial planning? The reason for the reminder is that during bull markets it is quite easy to get distracted by news reports and rising client expectations. Nowhere is this truer than in relation to developing portfolio recommendations for clients.

As background, this post was written during early fall 2018. The economic and investing environment during this time period can be described as almost unbelievably good. Late August 2018 marked the 10th anniversary of a bull market in equities. The ten-year run up in stock prices was, at the time, the best in the history of the U.S. markets. Tech companies led the bull market, with some stock prices jumping 1,000, 2,000, and 3,000 percent over the ten-year period.

There are numerous reasons for the ten-year bull market run. The reasons are likely interrelated, including favorable tax policies, a decrease in corporate regulations, and improved consumer confidence. Another factor may be related to simple statistics. Consider the concept of reversion to the mean. Here is how the folks at MathWorld define this concept: “Reversion to the mean, also called regression to the mean, is the statistical phenomenon stating that the greater the deviation … of a random event from its mean, the greater the probability that the next measured variate will deviate less far. In other words, an extreme event is likely to be followed by a less extreme event.” In practical terms, it is useful to remember the market lows of 2009 and 2010, and the fear and anguish that accompanied the multi-year drop in equity and home prices, in the most markets, worldwide.

The historic decline in market values set the stage for a classic reversion to the mean scenario. From 1928 through 2017, the S&P 500 returned 9.65%. Over the period 2007 through 2017, the S&P 500 return was 7.44%. The period from 2006 through 2011 saw a return of -0.20%. It is impossible to know how much money statisticians made after the market lows, but those that followed a basic reversion to the mean strategy probably made out nicely.
What would a revision to the mean strategy look like? It is not complicated. Once returns fall dramatically from the mean—as happened during the global financial crisis—an investor should take a contrarian position and invest heavily in the market. Of course, the opposite strategy comes into play when returns skew above the historical average.
Where does that leave things today? Over the period 2015 through 2017, the S&P 500 returned closer to 11% on an annualized basis. Some stocks within the index moved far beyond historical average return levels. At the average, including 2018 data, the market returns are a bit above what a statistician might expect.

Going into 2019, financial advisors need to ask if the bull market will continue or whether the market will revert to the mean. In the short run, a statistician might argue that financial advisors should expect a modest correction to bring market returns into alignment with historical returns. Strategically, this would require some financial advisors to reposition client assets more conservatively. Of course, as with any wager, if the statistician is incorrect, and the markets move forward strongly, those who reposition out of equities stand to encounter an opportunity cost.

This leads naturally to the economic concepts of fear and greed. A statistician who has witnessed the ten-year bull market run may be fearful in anticipation of a reversion to the mean. On the other hand, the same statistician may feel the impulse of greed and/or the fear of regret. After all, very few investors will happily look back at a chart of S&P 500 returns and congratulate their reallocation efforts when the markets surpass expectations. It is this constant balancing of fear and greed/regret that makes investing so interesting.

Let’s go back to the eight words that started this column: the majority of clients and markets are average. As a reader, if you have been following my columns in the Journal of Financial Service Professionals over the past several years, you will remember that the concept of risk tolerance comes up quite a bit. The reason is that a client’s willingness to engage in a financial behavior in which the outcome is both unknown and potentially negative is very important when determining the appropriate mix of assets to include in the client’s portfolio. Something curious, if not alarming, has been happening in terms of client risk attitudes lately.
The notion of reversion to the mean has already been discussed. The statistical evidence hints at a possibility of some type of modest market correction. The risk tolerance data that my students and colleagues collect on a daily basis is showing something different. Risk tolerance scores are moving away from the historical average. Specifically, risk tolerance scores have been shifting upward, indicating that individual investors are increasing their willingness to take financial risk. While we don’t yet have sufficient advisor data, the evidence that we do have suggests the same thing is happening among financial advisors.

The question is whether the historical average in risk tolerance scores is the reality or if the higher trending risk scores represent reality. Is this another one of Pascal’s wagers? Let’s think about how a statistician might view the trend. While it is possible that investors’ tolerance for financial risk has increased, it is also possible that investors are moving into dangerous territory in terms of perceptions of the investment markets. Consider again the past ten-year period. While there have been some pullbacks in asset prices, investors—those allocating assets to equities and real estate—have experienced very few negative shocks. Time tends to dampen emotions, which may help explain the shift in risk tolerance scores. Specifically, few investors or financial advisors are able to recall feelings of fear and regret that arose during the global financial crisis. Instead, what many investors are feeling today is the fear of missing out on future returns. As a result, financial advisors are being forced to nudge the risk profile of client portfolios higher. Advisors who buck the bull market and investor risk tolerance trends are taking a risk—the risk of alienating clients. Financial advisors who follow the trend, however, are also taking a risk—the risk of dealing with disappointed clients in the future.

As with the investment markets, a shift like we are seeing is possible. Investors may have permanently shifted expectations based on market perceptions and preferences. Investors may be willing to incur large potential losses for the possibility of achieving higher returns. If true, this bodes well for the market as a whole. Also, if true, this may explain the continuation of the bull market. However, if this change is transitory, which a statistician would say is the more likely scenario, financial advisors would be well advised to begin risk and return dialogs with clients sooner rather than later.

While reversion to the mean and shifting risk tolerance scores are not perfect predictors of future market behavior, these economic tools are worth considering in the context of other indicators and conditions. In the end, it is always worth bearing in mind that most markets and most people, by definition, are average. When returns and/or scores start to drift away from historical averages it is always a best practice to reevaluating previous assumptions and expectations.

 

[1] Wiesstein, E. W. (2018). Reversion to the mean. MathWorld—A Wolfram Web Resource. http://mathworld.wolfram.com/ReversiontotheMean.html

15-Year Retrospective Risk Paper to be Published

A retrospective review of the Grable and Lytton Risk Scale will be published later this year in Financial Services Review, one of the premier academic financial planning journals. Here is the paper’s abstract:

“Over a decade ago, Grable and Lytton (1999) developed, tested, and published a financial risk-tolerance scale in Financial Services Review that has since been widely used by consumers, financial advisers, and researchers to evaluate a person’s willingness to engage in a risky financial behavior. Analysis of data (n = 160,279) spanning the timeframe 2007 to 2013 provides evidence that the risk-tolerance scale’s reliability and validity have remained robust since the scale was first developed. The scale’s estimated Cronbach’s alpha was .77 during this time period. Consistent with the literature, high scale scores (representing a greater willingness to take risks) were found to be associated with equity ownership and negatively related to cash and bond holdings.”

The scale can be accessed at the following site: http://njaes.rutgers.edu:8080/money/riskquiz/

Surprising Risk Tolerance Finding

The financial risk tolerance team discovered something interesting today. The team has been tracking the daily financial risk tolerance of individuals since late 2007. Initial results from the lab suggest that the market does influence people’s willingness to take financial risk. The strongest link is between daily stock market volatility and risk-tolerance scores. When market volatility is up, risk scores drop. When volatility falls, risk scores go up. Generally, people are more likely to increase their tolerance for risk over time.

While these initial results are interesting, the FPP Lab Director, Dr. John Grable, noted, “It looks like the change in risk scores is actually rather small. This means that even though the markets appear to have an influence on subsequent risk attitudes, the actual change in tolerance for risk is not large enough to significantly alter current or future investment choices.”

The research team is currently engaged in a neural pathway analysis to identify other patterns in risk attitudes. Check back for results as they become available.