"The possibility of loss or injury" - That's the dictionary definition of the noun "risk."
However, while individual investors and finance professionals may agree on that basic definition of the word risk, they often think about asset riskiness very differently, and these differences can have real consequences for portfolios.
Here are three ways in which individual investors and finance professionals differ in their risk thinking, as well as a look at how individual investors can potentially mitigate the negative impact these differences can have on portfolios:
They measure risk differently. To measure risk, the finance industry focuses on an asset's return volatility and correlation with other assets. Huh? Let me break down those somewhat complicated terms. Return volatility simply means how dispersed an asset's returns are about that asset's average return over a certain period of time, including to the upside and to the downside. An asset whose returns are more stable is considered less risky, while an asset whose returns are more volatile is considered more risky.
For portfolios, professionals additionally focus on how correlated an asset's returns are with the returns of other assets in a portfolio. The lower the correlation, the less a given asset moves with the other assets in the portfolio, and the more it can potentially help reduce the portfolio's overall volatility or riskiness through diversification, and vice versa.
Individual investors, however, tend to be loss averse - experiencing the pain from losses roughly twice as strongly as the pleasure from equal size gains. As such, it's not surprising that they generally measure risk as the dollar loss on a given position, focusing their estimates around a reference point, usually the price at which a security was bought. In other words, risk for them tends to only encompass downside risk, and it's measured in dollar, rather than percentage terms.
In addition, when assessing risks, people tend to focus on individual security returns over a relatively short time period rather than on how a given asset relates to the portfolio overall. This kind of thinking underestimates the riskiness of assets that tend to move along with other portfolio assets, and overestimates the riskiness of assets that provide diversification benefits, leading to misinformed portfolio risk budgeting.
Their attitudes toward risk are determined differently. Modern finance theory usually starts with the assumption that investors' risk preferences are relatively stable. In reality, however, researchers have found that individuals' attitudes toward risk vary considerably with environmental and demographic considerations. For instance, researchers have found that the source of funds being invested matters to risk preferences, with people more likely to invest money from a lottery into risky assets than money from an inheritance. The source of risk is also important; inflation, for example, doesn't usually feel inherently risky to individual investors, as it doesn't change the nominal sum invested.
There are also demographic differences. Women tend to be more risk averse than men, although they get less so after marriage; for men, the opposite is true. Finally, how an investment opportunity is framed matters, with people often risk averse when it comes to achieving gains but willing to gamble to avoid losses. Yet, basing risk assessments and investment decisions on personal considerations, such as the source of funds, may result in portfolios inappropriate for the investor in question.
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.