I was late to work this morning – there was a crash on the other side of the dual carriageway. Like all of the other drivers, I had a quick nose and went on my way. But, like all of the other drivers on my side of the carriageway, I drove a bit more slowly and more carefully. It took me more time to arrive at work, so there was a cost resulting from the change in my driving style. If I drove more slowly and carefully every day, the lost time would start to add up.
This change in my approach to driving (and that of the other drivers on the road) wasn’t the result of a change in my personality or the way I approach the risks involved in driving. My driving style won’t have changed when I get in the car for the commute home later.
The temporary change in my approach was down to a change in my perception of the risk of driving. It’s only natural to take a more cautious approach when you see a risk become a reality.
And, after the events of recent weeks in the financial markets, our natural inclination is to want to take less risk. We’re at the equivalent stage of the car journey where we have seen the crash on the other side of the road, and we’re inclined to be more careful going forward.
But let’s not forget – there is a cost to this change in our approach. Driving more cautiously results in our arriving at work later, and those minutes will add up over time. Similarly, taking less investment risk might protect us against a crash, but most of the time, there is a cost as it will take longer to achieve our financial goals.
There are plenty of similarities between our approach to driving and investment risk taking (I’m not suggesting that faster drivers take more investment risk, by the way!). Our driving style only changes temporarily when we see an accident; likewise, our approach to other forms of risk, such as investment risk, doesn’t change if there is a bad outcome (like a crash in gilt prices). Our tolerance of investment risk and our approach to risk generally is a personality trait. However, there are times when we perceive the risk of certain things being greater (this is down to instinct – zebras are more nervous after one of the herd has been eaten by a lion!) – however, this isn’t a rational approach to risk, particularly as our behaviour only changes for a short period of time.
With investment risk, we shouldn’t be changing our approach after a market event. Our risk personality hasn’t changed, and there is a cost to taking less risk. If we start to take less risk, and the market recovers, our unchanged financial personality will be annoyed that we are missing out. Our approach to risk, including investment risk, is a personality trait.
It’s true that, over the decades, our personalities change. I’m a much more cautious driver now than I was thirty years ago. I would expect someone’s approach to investment risk to change over the long term too (there is very little evidence that we become more averse to risk as we get older, incidentally). However, studies have shown that our risk personalities are consistent over the longer term, and they don’t change from one year to the next, regardless of events in the investment world.
So, if you feel that recent events have made yourself more cautious, take a step back and consider whether it might just be that your perception of risk has changed. Ask yourself how you might feel if markets recover and you miss out.
There are many other valid comparisons between driving and investing. I’m interested in everything about investments, but start to yawn when people talk about their cars. My father-in-law can talk all day about cars, but starts to yawn as soon as I start to explain the Information Ratio for a fund. We are all different people and that’s what makes life more interesting (although Frank should really pay more attention to Information Ratios!).
Philip Wise | email@example.com
Managing Director and Chartered Financial Planner