At any given point in time, there is one major investment risk that becomes the focus of everyone’s attention. Sometimes this will be a new and significant event (such as the war in Iran); other times it will be a risk that has lain dormant but suddenly becomes the thing to care about (like the recent AI/software company flare-up). The problem is not just that we almost always end up misjudging the impact of these risks, but that there is an incessant stream of them. Many investors seem to manage their portfolios from one risk to another, month by month, quarter by quarter. Suffice to say, this is probably not a strategy that can be successful over the long run.
As humans, we tend to judge risks by their availability – that is, we assess the severity and likelihood of a risk based on how prominent and emotive it is. It is easy to see the evolutionary benefit of this: if you worried a lot about very obvious threats, you probably had a better chance of survival.
While this focus on available risk may be a very effective human adaptation, it is incredibly unhelpful for most investors. There are two major problems. First, our tendency is to hugely exaggerate the risks we face at any given moment. This is particularly pertinent for long-term investors, as there are simply not many risks that are likely to matter in a predictable way over the horizons we care about. Second, given that we cannot know how any particular risk will unfold, it is incredibly difficult to do anything useful about it. What should we do? Get out of the market until the next risk comes along and then see how we feel?
The other issue with availability is that it creates a conveyor belt of risks, where one salient concern is in focus at any given point in time only for another one to come along the following month. Not only is the world far more complex and interconnected than this would suggest, but focusing on one particular risk means we are not considering many others.
For an investor, the next geopolitical risk feels far more vital than the risk of, say, trying to time your equity exposure or selling out of equities altogether. We are only wired to care about one of these – the thing that is front and centre right now, which is making us feel something.
We also tend to act as if the risk that currently has our rapt attention is far more important than whatever was on our minds six months ago, which we can barely remember. We struggle to imagine that we will be worrying about something else with similar intensity in a few months’ time.
Although how some risks come into central focus is obvious – the current situation in Iran being a good example – others seem to become the topic everyone cares about out of the blue. It can be an underlying risk that everyone has known about for a long time suddenly starting to feel vital.
Cass Sunstein and Timur Kuran wrote about this idea and defined it as an “availability cascade”. This is the process by which belief about a risk becomes acute because it is visible and frequently repeated. The spread is driven primarily by informational and reputational factors, which are self-reinforcing.
How does this work? Imagine that during one balmy summer a diver is bitten by a shark off the coast of Cornwall. What happens next?
Informational cascade: News stories appear everywhere about dangers lurking in British waters. The incredibly remote risk of being the victim of a shark attack has not changed, but how we feel about it has.
Reputational cascade: You are taking your family to the beach in Cornwall. You know the risk of a shark attack from letting your children swim in the sea is virtually non-existent, but you also know what other people might think. Haven’t you seen the news? Imagine the looks from the other parents as you lead your children into the water.
Availability isn’t generally about imaginary risks; it is about real risks being overstated because of how aware of them we are.
We see this exact phenomenon all the time in financial markets – in the emergence of bubbles and in sporadic panics about certain risks. We are bombarded with what seems like information and feel compelled to react because everyone around us is.
It is almost certain that the advent of social media and 24-hour news has made these availability cascades more frequent and more impactful.
Managing an investment portfolio for the long term while reacting to each headline risk is not only exhausting but highly likely to lead to rash decisions and poor outcomes. There is no easy solution to this; the spectre of availability can make it costly to our reputation to ignore risks even when they are wildly exaggerated or imponderable.
For long-term investors, the risks to meeting our objectives are far more likely to stem from our reaction to headline risks than from the risks themselves.
Joe Wiggins is Director of Research at UK wealth manager, St James’s Place and publisher of investment insights through a behavioural science lens at www.behaviouralinvestment.com. His book The Intelligent Fund Investor explores the beliefs and behaviours that lead investors astray, and shows how we can make better decisions.
This article was originally published on Joe’s website, Behavioural Investment, and is reproduced with permission.