They form expectations about risks differently. Finance professionals usually assume that an asset’s riskiness is known in advance, or can be estimated using past volatilities and correlations.
In contrast, individuals’ risk expectations are sensitive to past personal experiences. For example, an individual who has experienced low stock market returns throughout his life tends to be more pessimistic about future returns and is less likely to invest in equities, viewing them as more risky than they perhaps are.
Similarly, a better macroeconomic backdrop can lead people to expect both higher returns and lower volatility. Finally, a past loss on a given stock can deter people from purchasing it again in the future. Rather than estimate future returns and volatilities, an investor may focus on the negative emotions of disappointment and regret that the purchase is likely to prompt in him, and he may distance himself from these emotions by avoiding that security.
Okay, now that we got these differences out of the way, here’s how individual investors can potentially mitigate their negative impact on portfolios:
Work backwards from longer-term investment goals. Portfolio risk levels should reflect not just risk tolerance but also targeted outcomes. For instance, the higher the desired wealth or the lower the starting point, the more risk an investor ultimately needs to take on to meet his goals, taking into account that investor’s time horizon of course.
So, rather than first focus on one’s current feelings about risk, investors should instead focus on how to achieve longer-term goals using diversified portfolio allocations.
Sources: Studies linked to throughout the post.
Nelli Oster, PhD, is a Director and Investment Strategist in BlackRock’s Multi-Asset Strategies Group. She holds a BSc (Hons) in Management Sciences from the London School of Economics and a PhD in Finance from the Stanford Graduate School of Business, where her dissertation focused on behavioral finance.
Diversification and asset allocation may not protect against market risk or loss of principal.