Perceived vs. Calculated Risk: It Could Make All the Difference

What I hope to highlight here is the fact that we should be using calculated risk to do an analysis of our investments over time. However, most of the time, people let their perceived risk of investments drive their decision making. That perceived risk is really not a calculation of legitimate data, it is based around FEAR and subjective outlooks which influence your decision-making processes. Let’s quickly break down what I am referring to here.

Perceived Risk: the subjective judgment that people make about the characteristics and severity of a risk.

Calculated Risk: a hazard or chance of failure whose degree of probability has been reckoned or estimated before some undertaking is entered upon

When I refer to perceived risk, I am hoping to highlight the emotional state of mind that develops based on fear, and the way that can impact the decisions we make within our investments and our life in general.  Worse than that, the fear that is driving these decisions is most often unsubstantiated and derived from the constant onslaught of negative or uninformed information that we are all taking in every day. By using calculated risk to determine both life and investment decisions, we will be taking that emotion out of the decision-making process and using quantifiable data to determine whether the risk being taken is outweighed by the possible return you could receive.

Terms like Alpha, Beta, R-squared, Standard Deviation, Sharpe Ratio or CAPM are all great measures. These are the measures myself and my partners use to make sure we are providing the best portfolios for our clients. As financial advisors, we are as much statisticians and financial analysts as we are therapists. We help control client’s emotions on a daily basis to help make sure they are making the best long-term decisions possible. I use the term perceived risk because the first issue with letting our brains determine what’s risky is the fact that our own fears will most likely cloud the rational judgment of how much risk we are taking. We attempt to remove those perceived risks and fears by using the aforementioned terms and practices presenting a considered, measured and clear calculated risk approach for our clients.  

So how do perceived or calculated risk mentalities relate to investors and decisions they make on a regular basis? Well, the term risk vs. reward has become quite cliché over the years but it is absolutely true. However, your approach to risk (perceived vs. calculated) can make all the difference. You can’t get any return on investment without taking some risk. I hear perception about the risk you’d take if entering the stock market being far too high to be worth it. Because of that, people delay investing money for years until they realize they won’t be able to outpace inflation without the returns the stock market provides. At that time, they have missed the opportunity for serious returns due to the time value of money…a result of perceived risk based on subjective judgment. Or worse, they delay until the market has risen so much that they decide they are missing the boat and then get in at market highs. Then when the market invariably corrects, they say, “see I was right this is just gambling and way too risky for my life savings.” Then exit the market at the most inopportune time.

To fray some of this risk, investors do a whole litany of things that don’t actually reduce risk from their investments. They hold money at many different firms as if having an account at T. Rowe and one at Fidelity and one at Schwab somehow limits your risk. Again, a perceived risk mentality. A calculated risk analysis would prove that to be false. The underlying investments you are holding at each of those firms is what is deciding your current level of risk. Being spread across firms can actually increase the risk you’re taking because you could have extremely correlated investments between the firms that don’t compliment themselves in either up or down markets. Having your investments work together to achieve your goal return is really what we are after.

Furthermore, people will make a mad dash to pay off their houses (we covered this in an earlier post) or hoard cash, which is actually losing money to inflation every year…calculated risk analysis will prove that. People will blindly fill their portfolios with bonds no matter the interest rate environment, and they will buy a penny stock in the hopes of getting rich quick rather than buying companies who are doing the one thing that actually moves stock price more than any other, grow their earnings…another result of choices based on perceived risk.

Now for the readers who are familiar with MPT or Modern Portfolio Theory, it might surprise you to hear me say including bonds in your portfolio doesn’t necessarily mitigate risk. But in my opinion, and this can be backed up by tons of data, over the long-term, it doesn’t. Certainly, the larger percentage of bonds you have in your portfolio in a year where equities are losing value the less your portfolio will lose. Typically, 2 out of every 10 years in the market will be losing years for equities and if you were holding bonds during those 2 years you certainly made out better than a portfolio of 100% stock. However, how much have you lost in potential return over the entire 10-year period by including bonds as a major part of your portfolio during the 8 years the market was rising? The answer is, far more than you saved by being in bonds for the down years.

Keep in mind that bonds do have their place in a portfolio, but not if Growth is your overall objective. If you are retired and you are looking to create a retirement income stream, then bonds can and should play a role in your portfolio construction. But for the group of dollars that we are trying to grow, equities, and more specifically stock of companies that are continuing to grow their earnings is where you want to be long term.

Apologies for getting a bit technical or calculated there…it’s hard for me not to do. Let’s bring it back to the topic at hand, Perceived Risk vs. Calculated Risk and the impact those two terms have on the financial and day-to-day decisions we make. When defining the two terms, I suggested that fear plays a role in perceived risks. So, let’s ask the question…where does the fear come from?

This can be a different answer for every person asked, but 9 times out 10 whether people know it or not I believe it is the information that they are taking in. I can’t explain enough the importance of optimism. And it is very hard to remain optimistic in our current news climate. We are constantly bombarded by media marketing and most of the time that media projects a negative if not awful view of the world. It’s intended to increase their audience and what better way to do that than by scaring people? Getting them hooked on irrelevant information that most of the time when looked at with a much wider lens and with some depth of thought can be easily dismissed.

A few examples, between 2000 and 2012 the rate of absolute poverty in the world has fallen by HALF, this is the fastest increase in economic development in human history. Rates of child mortality in Africa are now lower than they were in Europe in 1950. Children there have more access to fresh water and immunizations than ever before. Violent crime is now at the lowest level it’s been in 40 years. The 2015 violent crime rate was ¼ of what it was in 1993. And yes, this included gun crime. Yet we are drowning in news stories constantly about how we need a radical change in the world because things are going horribly wrong. We certainly have much farther to go in many respects but we as a country and as a planet are moving in the right direction much quicker than we could have ever anticipated. But how would any of us know these things when constantly being backed into a corner of fear when we turn on the TV or read the paper? The answer is, don’t take everything at face value, read, learn, fact check, and most importantly be optimistic about the future.

Unsubstantiated information will bread fear, and that fear will inevitably impact the decisions you make in all aspects of your life.

I’d like to give an example of this based on my own life. As many of you know, I am an avid motorcycle rider. Now many of you, right off the bat, will write that activity off as too risky to pursue. I will go into why I believe it to be worth the risk later but for now, let me discuss how certain aspects of riding are perceived to be riskier than others when that is generally not the case.

My wife Anne loves to ride with me. It is an escape for us like no other. It bonds us together with something that requires trust and passion. The cornerstones of any successful marriage. However, my wife (as well as many other wives that ride) have a fear of riding on the highway for long periods of time at normal highway speeds of roughly 70-75 mph. Typically, those aren’t the most scenic trips anyway so we try and avoid the highway. But now and then if our ultimate destination is quite a ways away we might take the highway in one direction and backroads on the way back. Traveling at double the speed around cars that are also traveling that fast? Well, you must have a far greater chance of death correct? I can tell you unequivocally that riding on back roads is FAR more dangerous than riding on an Interstate like 95.

I’m sure most of you non-riders are raising a brow at that statement. But let’s get out of our own fears and forget the fact that we are nearly doubling our normal speed and think rationally. On the highway, I can stay in one lane, at one speed, and only have to worry about the lane to my right where a car is traveling at a somewhat similar speed. Those cars on my right-hand side, as well as the possibility of road hazards, are really my only concern. Conversely, while riding on backroads I have many more concerns and risks to watch out for. First, road hazards which could exist in either scenario are far more commonplace and can be much harder to avoid as there could be no shoulder or other obstacles to deter you from missing the hazard. Also, if riding at night, they can be much more difficult to see as backroads are typically not as well lit as major highways. Furthermore, I have many other things to watch out for. Cross streets, drivers not aware I am even beside them, large animals like deer, and oncoming traffic not separated by a median.

There are more but I will leave it there as to not bore the reader with my motorcycling analytics. Point is, my wife’s fear of riding on the highway isn’t necessarily one based on reason it is based on emotion. Fear more specifically.

When we actually start thinking about what will drive investment growth and therefore the growth of your own wealth, being invested, staying invested, and focusing on the things that really matter within your investments (earnings) is what you need to do. Push out all the irrational fears and clouded hearsay out there and find a trusted advisor to walk you through their investment strategy. If they can clearly and concisely answer the 3 major questions, what will you buy, when and why will you sell it, and what will you re-invest my proceeds in, then consider taking them on as a trusted advisor. But please do not let fear drive your decision making.

I am asked all the time, “Aren’t you afraid your children will follow in your footsteps riding motorcycles?” And my answer is always the same. “I’m teaching my children to chase their passions, not live in fear.” If those passions happen to overlap with something others would consider dangerous does that mean they shouldn’t live a passionate life? I have my best ideas, both personally and from a business perspective while riding. I find the uninterrupted relaxed concentration crucial to opening my mind to new ideas and original thought. That’s why riding, for me, is worth the calculated risk.

- Christopher Wakeman, Managing Partner, Lignum Wealth Management