How’s your vision?
Source: Wikimedia Commons. CC0.
I need to get a vision test soon. I’ve had glasses since I was about 12 years old, but I was too vain to start wearing them until I was in college. One morning, while squinting at the professor’s notes at the front of the classroom, she stopped her lecture, stared down at me, and commanded: “Stop glaring at me!” That was the final straw – it was time for me to get a new vision test and wear corrective lenses.
Now I get my eyes tested every couple of years. It’s amazing how quickly they can zero in on finding exactly the right prescription to correct my vision. The process takes less than an hour and they’re incredibly efficient and precise, running through a series of A/B tests using different lenses. “Does it look clearer with this lens or this?” they ask. In my case I have several different corrections: I’m nearsighted, I have astigmatism, and I need to adjust the direction my eyes naturally point – there’s directional a prism put into my lenses. There’s no reading correction yet, although my eye doctor tells me that’s just a matter of time.
It struck me recently that our approach towards risk is a lot like our eyesight. Everyone is different, whether because of our circumstances or our upbringing or our experience, or something else. Financial risk is incredibly important to investors. Risk is the price everyone pays to get returns. The level of risk investors can take is a central pillar of their Investment Policy. But we can’t understand how we’ll react to investment risk by simply filling out a form, any more than we can get a correct prescription for eyeglasses by just reading an eye chart.
Risky business? Military paratroopers in an exercise in Italy. Source: Wikimedia Commons. Public Doman.
A comprehensive risk profile depends on measuring our attitude and aptitude towards risk along several different axes. There’s risk capacity – how much risk we’re able to take. There’s risk aversion, whether we’d prefer a sure thing, or something with more upside. There’s loss aversion, measuring the same preferences when we face unpleasant outcomes. And there’s reflection, the tendency of some people to increase their bets when facing losses to get back to even.
Understanding our attitude towards risk along these four axes requires a series of A/B tests, like an eye exam: “Would you prefer this approach or this other one?” And the questions should be adjusted by circumstances and prior responses. Asking a multi-millionaire how they would feel about a $100 investment loss is probably a waste of time, as would be questions about betting outcomes to someone who is morally opposed to gambling.
I’ve written before about measuring investment risk, how it comes in different categories and flavors, how it can be transformed but never eliminated. Even “risk-free” investments carry risks, depending on the terms. The essence of risk is this: our knowledge is about the past, our investment decisions are about the future, and we don’t know the future. But we can know ourselves. To be successful investors, we must.
Having a clear vision of risk is crucial to setting an investment approach we can live with during uncertain times. Because the times are always uncertain.