The Biggest Myth about Risk You Must Be Aware Of

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Just 5 minutes ago before I started writing this article, I had completed a risk profile questionnaire prepared by the bank HSBC; there’s no reason I had chosen the one from HSBC other than it being the first link that appeared when I Googled “risk profile questionnaire”.

I had obtained a score of 36, which HSBC classifies as “Speculative.” I can’t know for sure, but I would gather that if I had approached the bank for investment-related products, they would tailor a portfolio for me that suited my “Speculative” risk profile as though it were a constant thing.

Now, the part in italics is incredibly important because profiling an investor for his or her risk tolerance and assuming it stays constant is basically standard practice in the financial industry. But, an individual’s appetite or tolerance for risk likely never stays constant. 

According to this intriguing New York Times article titled The Biology of Risk”, the author John Coates shared how people’s risk appetite can be influenced greatly by their surroundings.

Coates, a former Wall-Street trader and now researcher at Cambridge, wrote about the stress response mechanism in the human body. When we face stress – which can be of the physical, mental, or emotional types – our body responds by increasing the levels of the cortisol hormone (a.k.a. the challenge response). And, there are two interesting things related to cortisol.

Firstly, the level of cortisol spikes up when the level of uncertainty in our environment increases. Coates describes it as such: “If a person is subjected to something mildly unpleasant, like bursts of white noise, but these are delivered at regular intervals, they may leave cortisol levels unaffected. But if the timing of the noise changes and it is delivered randomly, meaning it cannot be predicted, then cortisol levels rise significantly.”

Secondly, the amount of cortisol in our body affects our appetite for risk-taking. In his article, Coates related two separate experiments he once conducted. In the first experiment, he found that traders’ cortisol levels grew over an 8-day period along with an increase in volatility in the financial markets. The next experiment saw Coates raise the cortisol level in volunteers by medical means and found that “volunteers’ appetite for risk fell 44 percent.”

So, if you put the two interesting things together, what you’ll end up with is this: An individual’s risk profile may never be constant. There can be all kinds of environmental changes not within the individual’s control that can affect his or her risk appetite by causing the level of cortisol in the body to change. As an investor, this has huge implications for how we should think about risk.

With Coates’ framework on cortisol and risk-taking, it now seems easy to see why investors often flee the markets just when they should be buying. Under the framework, volatility (and thus uncertainty) is heightened during market crashes; this raises the cortisol levels for market participants and thus reduces their appetite for risk, ultimately leading to them shunning the markets.

So if what’s immediately above really is true, how then can we minimise the odds of us falling prey to rising cortisol levels and fleeing the markets during crashes?

One particularly useful action practiced by the legendary investor, Sir John Templeton, may help. Templeton was known for always having a list of shares that he wanted to buy, but only at lower prices. He would do all his calculations in mundane- or bull-market conditions and then keep the list locked up. When markets inevitably fall, he would pull out the list, steel his nerves, and buy. Sometimes, he would even take things one step further and actually have standing orders with his brokers to purchase shares of certain companies if they ever fall to a price he liked.

During market crashes, the kind of buying-discipline Templeton displayed is something we can all learn from and which might help mitigate the pesky issue of spiking cortisol levels.

It’s been more than five years since Singapore’s share market had experienced a truly great crash. The Straits Times Index (SGX: ^STI) had fell from a peak of 3,876 points in October 2007 to a bottom of 1,457 points in March 2009; since then, it has more than doubled to its current level of 3,271 points.

We’ll never know when the next market crash will happen, but we know it will happen someday. When a fierce bear market finally rears its ugly head again, keep in mind the possible physical changes that might happen to your body and try to adjust your investing-behaviour accordingly.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore writer Chong Ser Jing doesn’t own shares in any companies mentioned.