THE RATIONAL PORTFOLIO: Behavioral Finance and the Psychology of Risk-taking

The field of behavioral finance has grown in leaps in bounds over the past several years and the psychology of risk-taking has helped investors better understand the implications of their decision-making. There are investors who naturally think in terms of their total wealth and view their portfolio as a blank slate every year. Conversely, there are investors who get physically ill at the thought of losing money, or who make quick changes whenever worries about not having enough cash for retirement ratchet up. Regardless of where you fall on the spectrum, we know that one’s predisposition for risk-taking can be reshaped, and the brain can be trained to respond differently to changes – including portfolio gains and losses.

For investors, it begins by establishing an on-going dialog with your advisor around three questions:

How much can we lose?
How repeatable is our process?
How educated am I?

1. Understand the risk by asking, “How much can we lose?”
With every investment program that CWA and Tectonic recommends, we look at the risk of loss and stress test the portfolios for various scenarios that could unfold in the markets. This includes looking back over an investment manager’s history to see how they’ve handled periods of stress in the market. By creating these scenarios we can get a realistic view of how a portfolio, as a sum of its parts, could perform going forward.

2. Predictability is key. Is the process repeatable?
With any strategy, it’s important to know if an investment manager is employing principles that can be repeated in the future. By combining risk metrics with portfolio analysis, it can reasonably be determined if a manager relies on luck, or some fortuitous positioning at one point in their career that has made their track record appealing. A good manager will have achieved success in multiple market environments using a repeatable, adaptable strategy. This is key in an ever-changing marketplace.

3. Set knowledge-based expectations. Ask yourself, “How educated am I?”
Having proper expectations is very important for both the client and the advisor. The “Holy Grail” investment that always goes up and never goes down simply does not exist. Inevitably, there will be some losses as part of the process of creating wealth. Good planning, however, requires the investor to be knowledgeable, aware and educated on their portfolio. Study on your own to learn about your investments. Also, ask yourself if your advisors and the managers they work with are transparent. Do they work to help you understand how your money is invested? It’s important to work with a team who views your portfolio holistically and communicates a variety of potential outcomes with you. Having a solid foundation of knowledge around how and why gains and losses could occur fosters sound decision-making.

Whether you can sleep through an earthquake, or if the slightest shift causes you to seek shelter, remember, your risk tolerance isn’t the determining factor in a rational portfolio. The investor-advisor dialog is the difference. Ask the questions. Know the answers.

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