How should we manage risk? There are two basic rules: diversify and avoid regret.
The first is simple: diversify. Let’s think about the example of a middle-class investor who save for retirement using a 401(k) account that contains a portfolio of investments. The 401(k) mechanism has become extraordinarily popular among both employees and employers.
Employees like it because it provides them with some control over the retirement savings while they get the benefits of a tax-deferred account. Employers like it because it reduces their risk, they are on the hook for an unknown amount of future payments as was traditionally the case for pensions and other defined-benefit plans.
When economists conducted a conference of survey of the investments held in the retirement savings accounts of employees, in the 20 largest 401(k) plans they found something concerning: on average these employees held almost half of their retirement savings in the stock of a single company their own employe.
Now in many cases employees can invest in their own company stock at a substantial discount and that makes a good purchase that stock in the first place, but there are two very good reasons to sell company stock as soon as possible which for most employees of large firms is immediately.
First the price of a single stock fluctuates much more than that of the broader stock markets. In the case of these employees company stocks more than twice that of the benchmark S&P 500. such fluctuations are especially bad for people nearing retirement age.
But, people actually hold more company stock the closer they are to retirement. Second the price of your company stock is correlated at least partially with your own job security. So a colossal disaster of some product failure or scandal could cost you not only your monthly paycheck now but also most of your savings for the future as unfortunately experienced by employees and well-publicized company meltdowns like that of Enron in 2001.
An optimal portfolio
In essence using your own company stock as a cornerstone of your retirement planning introduces an unwanted correlation between your income and your retirement savings that increases the risk of your financial portfolio. An event out of your control like the fraud of a top executive could have a catastrophic effect on your finances.
The Nobel laureate economist Harry Markowitz develop an elegant approach to managing investment risk. His central idea was that an optimal portfolio should contain assets that are not correlated, that do not tend to move together over time
new investments won’t reduce the risk of a portfolio if they are largely correlated with existing investments.
So it doesn’t necessarily improve your portfolios diversity when you buy into a new hot stock or take on yet another large cap mutual fund. For the sorts of investments most people make this approach prioritizes one type of investment: broad mutual funds that reflect the overall performance of the larger financial markets.
That doesn’t mean such investments are the only reasonable strategy for retirement, but there are indeed very strong reasons to value investment diversity when trying to manage risk.
The second rule also simple: avoid regret. This rule seems either meaningless or impossible we all have regrets even despite our best intentions. What I mean here is that you should think about risk a bit differently so the bad outcomes don’t lead to regret.
Let’s think to a coin flip game. In that game neurologically normal people showed regret when ever the risky choice led to a bad outcome. They tended to retreat immediately to safety costing the money in the long run the people with damage in their orbito-frontal cortex didn’t show regret. They didn’t move to a lower value save option and they made more money overall.
So, would you or your stockbroker be better off if you had orbital frontal brain damage? Of course not! Losing feelings of regret would be catastrophic in many real-world decisions. It’s often good to regret or mistakes so that we learn and we make better choices next time. But that regret does little good when investing. Because high reward investments tend also to be high risk it is good if we can dampen down our feelings of regret when necessary.
One effective approach for doing this comes not from behavioral economics but from clinical psychology. Psychologists have long been interested in strategies that help people dampen down their emotional reactions. Such reappraisal strategies can be very helpful when dealing with adverse events that are outside one’s own control.
Thinking like a trader
Researchers have explored a particular strategy called thinking like a trader. To do this think of yourself as a dispassionate observer of your own investment portfolio. Each of your investments is part of a larger whole any one of your investments might go up or might down on any day. Expand your time horizons, don’t think about the days or months market results, but instead think about your prudent well considered approach toward managing risk.
Each decision you make as part of your larger strategy. It isn’t even meaningful to regret one decision or one day’s market fluctuation by itself the larger strategy and the long-term results are what matters. By expanding your time horizons and perhaps not checking your stocks is often will be much better off.
I can’t promise you make better investments that’s a much more complex process and could be covered in any lecture, but what is reasonable is to seek a more healthy attitude toward risk.