Why Invest? - Part 2

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This is the second part of a two-part essay; part one is available here.  This article is intended for the educated layman. It was written as part of a continuing series of articles on a variety of investment topics.  To view all the articles in this series, click on “More by the same author” in the left margin.

The story so far

In Part I, we saw that America’s present acceptance of investing as appropriate and advisable for everyone, and not just the wealthy, sophisticated, and devil-may-care, is the result of a cultural development over the course of the first half of the twentieth century. From this arose the usual arguments for investing, which put the growth of your money at the fore. But there is a sound reason not to jump into the market with both feet: You might not like the risk in there. Our recognition of this brought us to the concept of risk tolerance, a quality inherent in an individual or an institution. Whether quantified or not, risk tolerance is the amount of return the investor requires as compensation for the extra risk that comes with investing. It’s a concept that is essential for making investment decisions, yet it is elusive and maddeningly difficult to specify. Even so, many investment advisors like to give the public the impression that they’re proficient at determining it. At the end of Part I, then, we found ourselves in a fix: We need to know our (or our clients’) risk tolerance, yet the usual ways of evaluating it, including the ostensibly objective tool of a risk tolerance questionnaire, won’t work.

Part II: How we do it, and how far can we go

There are only two ways that I can see out of this bind, at least until an economic theorist comes up with something better. One is to depend on the touchy-feely, after all. As unreliable and untrustworthy as intuition may be as an investment guide, I believe that a good investor or investment advisor, one who understands the statistics of investments, and who has self-knowledge and empathy for his clients, must make judgments of his own or of a client’s level of risk tolerance. When making the determination for others, however, the investment advisor has to engage in a dialogue to ensure that the client understands what the prospective returns and risks are. If you’re the client, you must know what your advisor is talking about when she talks about risk. Some of the questions on a standard risk tolerance questionnaire might prove useful if they facilitate this conversation.

The other way out of this bind requires that we look at the return-risk tradeoff differently, so let’s continue to hike to the end of the first trail before returning to this junction and taking the alternative route.

Evaluating risk tolerance

The intuitive measurement of risk tolerance has one advantage over any attempt to measure a precise numerical value: It is practicable. And in practice, many investment advisors represent their judgment of a client’s risk tolerance in either of two ways that anyone can grasp. (Whether they do so accurately is another matter, depending upon their knowledge and skill.) The representation can be verbal, like a choice from the usual range of descriptors, “aggressive” or “conservative” and so forth, or, more usefully, it can be expressed as the proportion of stocks to bonds the investor should hold in a simplified portfolio. For example, as an investment advisor, I might weigh your situation and your words and conclude that your risk tolerance is best represented by a portfolio of 60% stocks and 40% bonds. By this I’d mean that, knowing the historical statistics for the S&P 500 index (representing stocks) and an index of the bond market (like the Barclays Capital Aggregate Bond Index), I think that such a simplified portfolio would historically have matched your risk tolerance. The neat advantage of this representation is that it’s numerical, with the result that, although I’m not measuring your risk tolerance directly as a number, the upshot is the same, because that historical stock/bond portfolio, with its percentage allocations and historical values for return and risk, is just as clear and precise as a direct measurement, were one possible.

Can risk tolerance change?

Although economists and investment advisors speak of risk tolerance as if it were a more or less immutable personal characteristic that inheres in the investor, it has, in practice, always been subject to negotiation. The mutual fund salesmen whom I cited in Part I of this essay, trying to persuade you to invest in the stock market, are attempting to alter your risk tolerance (though dishonestly, because they hide the risk). Newsletters and magazines for professional investment advisors like me are full of advice on how to manage clients who panic at the latest market swoon. And an advisor who converses with a client about risk in order to gain the measure of the client’s risk tolerance is not only measuring it; she’s almost inevitably influencing it at the same time. That is, she’s determining it in both senses of the word.

No less an exemplar of the wise investor than Warren Buffett has attempted to modify the public’s investment risk tolerance. In a famous essay, he retells a sort of parable first offered by Benjamin Graham, his mentor and the doyen of modern securities analysis:

Ben Graham, my friend and teacher, long ago described the mental attitude toward market fluctuations that I believe to be most conducive to investment success. He said that you should imagine market quotations as coming from a remarkably accommodating fellow named Mr. Market who is your partner in a private business. Without fail, Mr. Market appears daily and names a price at which he will either buy your interest or sell you his.

Even though the business that the two of you own may have economic characteristics that are stable, Mr. Market's quotations will be anything but. For, sad to say, the poor fellow has incurable emotional problems. At times he feels euphoric and can see only the favorable factors affecting the business. When in that mood, he names a very high buy-sell price because he fears that you will snap up his interest and rob him of imminent gains. At other times he is depressed and can see nothing but trouble ahead for both the business and the world. On these occasions he will name a very low price, since he is terrified that you will unload your interest on him.1

Most readers have taken this passage to be about how to take advantage of the market’s setting the prices of stocks and bonds below their intrinsic value. But, as Buffett says, it is really about “mental attitude,” that is, risk tolerance. Graham and Buffett are instructing the reader to be tolerant of drops in price (albeit only of the stocks and bonds of what they deem to be solid enterprises).

1. Warren E. Buffett, The Essays of Warren Buffett: Lessons for Corporate America, ed. Lawrence A. Cunningham, 2nd ed. (Published by the editor, 2008), p. 78.