When risk aversion makes investors less successful

Risk aversion should be a useful trait for investors, protecting them from the worst turbulence in securities markets and leading them to avoid bad investments. It is a natural response for people who have worked hard to earn their money and don’t want to lose it. However, too often it keeps them invested in the wrong assets at the wrong time, leaving them poorer over the long term.

Risk aversion among people over their management investments and wealth can manifest itself in a variety of ways. The first is an inclination to hold cash rather than invest in shares or even bonds. According to the latest BlackRock Investor Pulse, the largest survey of investors in the world, 57% of people surveyed do not place any of their savings in market-based investments; among them, 27% said they were afraid of losing everything.

The inclination to hold cash was a significant destroyer of long-term wealth during a decade and a half when interest rates were at or close to zero meaning cash savings were mostly outstripped by inflation. A sum of €30,000 earning no interest would see its real value fall to €20,200 over 20 years, assuming an inflation rate of only 2%. Since then the equation has changed for even worse, with inflation soaring in 2022 and early 2023 – and interest rates on savings accounts failing to keep up.

The inclination to hold cash was a significant destroyer of long-term wealth during a decade and a half when interest rates were at or close to zero meaning cash savings were mostly outstripped by inflation.

Capital preservation

A second problem with risk aversion is that investors prioritise short-term capital preservation over growth. Since the global financial crisis, when equity markets lost around 40% of their value, investors have been wary of stock market investment and the associated volatility. Since the onset of the Covid-19 pandemic, equities have suffered from repeated bouts of turbulence, and stock markets worldwide fell in value in 2022.

Investor fear of sudden market plunges has prompted the launch of multi-asset funds and other investment strategies that aim to reduce volatility while providing a greater return than cash. Intuitively, this may feel safer, but it may also affect the long-term capital growth needed to provide a comfortable retirement, for example. Between 2009 and 2020, stock markets delivered impressive total returns. For long-term capital growth, investing in and staying in the markets, and avoiding panicking during temporary downturns, is vital.

If anything, there are strong arguments that investors should take greater risk in their stock market investments. Many equity strategies aim to minimise downside risk, and give investors as smooth a ride as possible, but comfort can come at the expense of long-term returns.

Identifying high-growth stocks

Research by Hendrik Bessembinder, a professor of finance at Arizona State University’s W.P. Carey School of Business, has found that stock market returns are concentrated in a few high-growth companies – miss them, and you might as well be holding government bonds. According to Prof. Bessembinder, over a 90-year period more than 95% of companies in the US market delivered no value for investors.

He says all of the $35 trillion in wealth created by stocks that exceeded returns from Treasury bills between 1926 and 2016 can be attributed to just 1,092 companies, 4.3% percent of the nearly 26,000 stocks traded in the market over that period. More than half of that $35 trillion came from just 90 companies, less than one-third of 1%.

This is a difficult piece of research for investors to digest. It means, in effect, that the key to expanding one’s long-term wealth is to identify these high-growth companies – even though they are likely to be volatile and may frequently look expensive. These results also help to explain why poorly-diversified portfolios underperform market averages.

Diversified portfolio

It’s worth noting that Amazon was considered to be extremely expensive in 2000, when its share price was $0.78; it made little or no profit until 2005, despite its growing sales volume. At the end of June 2023, its share price was nearly $128, having reached a peak of $172 in December 2021. This is an illustration of how risk aversion can prevent investors from obtaining the maximum benefit from stock markets growth.

However, it also demonstrates the importance of a well-diversified portfolio, which increases the likelihood that some stocks within it will emerge as top performers (and compensate for laggards). Investors also need to hold those stocks long enough to enjoy realisation of their true value. That can be achieved by investing in one or more passive funds – usually exchange-traded funds – with a broad spread of stocks from a stock market index, or selecting an active fund manager with a track record of picking future big winners.

We suffer losses far more profoundly than we enjoy gains.

Deep-rooted psychological traits underpin risk aversion. Behavioural economists say we suffer losses far more profoundly than we enjoy gains. Psychologists Amos Tversky and Nobel economics prizewinner Daniel Kahneman developed prospect theory in the late 1970s, determining how individuals make choices between different outcomes – for instance, whether to buy an investment with the prospect of long-term gains but the potential for short-term losses, or to prioritise capital preservation.

Quest for certainty

Their research found that investors tend to like certainty; people prefer certain outcomes and underweight outcomes that are only probable. This is understandable in the context of markets, where the potential upside may be high but inherently uncertain. Cash and low-risk fixed income investments provide certainty or at least greater probability. Investors are happy to know they will at least get their nominal amount of money back, even if its purchasing power has been eroded by inflation.

It should also be noted that the perceived risk of stock market investment is lower than most people believe – as long as investments are held for the long term. Analysis by UK-based financial adviser Willis Owen found that in only six periods out of a possible 281 over a 33-year stretch could investors have lost out from putting money in the stock market for 10 years.

Loss mitigation strategies

In general, these periods arose when investors put money into the stock market at its peak, just before a crash – on January 31, 1999, for example, or just before the 2007-09 financial crisis. But otherwise investors did far better, earning an average return of 139% over a decade.

In most cases, these – very rare – losses could have been mitigated by a strategy of regular monthly investment, rather than putting all one’s capital into the stock market at the same time. Under this strategy, dubbed dollar cost averaging, an investor can buy the same cash amount of one of more investments at regular intervals.

Risk aversion can be the investor’s friend, but only to a limited extent. Misunderstanding of the level of risk in stock markets, as well as prioritising short-term capital preservation over long-term wealth creation, can leave them worse off. The data says that the best approach for investors is to take more risk than they would do by instinct, and to persevere for the long term. Or even better, to understand that taking risks can lead to opportunities while fears can lead to significant and costly behavioural investment mistakes.