New York, New York…
Imagine the excitement. In a moment of spontaneity, you’ve decided to treat yourself and your other half to a last minute trip to New York. You’ve selected the hotel, managed to get reservations at some highly recommended restaurants and even tickets for a Broadway show, which you’ve heard so much about. You’re scheduled to travel exactly one week from today…the date of the trip: September 14th, 2001.
A few days later, you watch with stunned horror the news reports showing the 9-11 terrorist attacks unfold.
The airports eventually reopen. Your flight is scheduled to go ahead as planned. How do you feel about getting on that plane?
Most likely, you feel uneasy, probably very nervous. You certainly feel far more uncomfortable about flying than usual. You tell yourself that it should in fact be far safer than normal given the heightened security. It’s unconvincing. It doesn’t feel that way.
Perceptions of risk
It is human nature that our perceptions – or feelings – of risk are greatly influenced by recent experience or events we can recall easily. We struggle to think probabilistically or engage ‘System 2’ thinking, “the mind’s slower, analytical mode, where reason dominates”. Flying seems much more dangerous shortly after news of a terrifying high-jacking than it did beforehand. That is even if, objectively, the risk of a subsequent attack has diminished.
The same mental and emotional processes occur as each of us considers their investment portfolio. Try as we might, we cannot help but feel something about possible investments, whether they are feelings of comfort and safety; danger and risk; or even embarrassment and ridicule.
Recent or particularly memorable price performance plays a large role in determining how we feel about an asset. Buying portfolios of thousands of US mortgages packaged together didn’t feel very risky until after a nationwide housing downturn and financial crisis, which few considered possible ahead of time. Investing in equities felt a lot more risky after a decade including two major downturns than they had previously.
The biggest risk
Each month, Bank of America Merrill Lynch publishes a survey of professional investors which usually makes for an interesting read. It includes the question: “What do you consider the biggest ‘tail risk’?”
Changes in the responses to this question over time confirm any suspicion that perceptions of risk are unstable. Most professional investors are no different. Humans are poor at calibrating probabilities and change their mind about them frequently.
Two recent examples illustrate the point: (i) North Korea and (ii) perceptions of a ‘crash’ in the bond market.
In July, North Korea was not even mentioned as one of the seven most popular ‘tail risks’ facing investors. By September, it was easily the most popular response with 34% of the vote. A month later, October’s survey for some reason revealed investors perceive North Korea to be less of a danger in relation to other candidates, with its vote share dropping to 23% (second place).
Why did the risk suddenly jump? Has it somehow receded?
In light of the fact that North Korea’s dynastic, authoritarian regime has conducted missile tests for decades and announced six nuclear weapons tests since 2006, an objective analysis would question the survey’s conclusion that risks posed by North Korea have fluctuated up and down so dramatically in a few months. President Trump’s reaction might be more unpredictable than his predecessors and therefore present an added dimension, but that was as true in October as in September.
In reality, no one, save a few people in the world perhaps, knows the true risk posed to the world by the North Korean regime since we cannot know what goes on behind the scenes. Periodically, missile tests and the accompanying media frenzy, however, serve to remind us of risks most people are willing to ignore most of the time.
Similarly, perceptions of the risk of a ‘crash in global bond markets’ has fluctuated notably in recent months, this time in response to short-term price movements. In July, just after bonds had suffered a sell-off, a bond crash was the most popular response to the question with 28% of respondents considering it the biggest risk. As bonds recovered in August and September, respondents breathed easy again, deciding other risks were more significant. October’s survey, however, showed a notable pick-up in concern of a bond market crash. Funnily enough, this followed a short-term decline in bond prices during the second half of September.
To the extent that financial markets are subject to noisy and random short-term price behaviour, one might think the risk of a large sell-off in an asset price would be greater were the price high rather than after it had already fallen in value. This would be logical. It is not how we feel, however. As the BofAML survey demonstrates, things feel riskier after we have been reminded they can fall in value, just as they feel safer if the investor experience has been a good one.
Acknowledging we are human means realising each and every one of us are prone to unstable and inconsistent feelings, which can lead us to make mistakes when assessing probabilistic choices, such as the risk and reward potential of an investment. Objective analysis doesn’t come naturally. Self-awareness and an investment process which takes into consideration our ‘humanness’ is the best chance of overcoming the challenge.