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Suddenly, in the past few weeks, the markets have looked a lot scarier to a lot of nonprofessional investors in the U.S. market. Why? The answer probably has something to do with human psychology.
As many of you know, an Australian company called FinaMetrica has been giving lay consumers a scientifically-designed risk profile questionnaire for the past 12 years, helping financial advisors evaluate whether their clients are natural risk-takers or the kind of people who feel more comfortable if their money is stuffed safely in their mattress.
A closer look at the responses, including 2,586 individuals who took the test before and after the recent bear market, shows something surprising: people were no more risk-averse after they had been clawed by the worst bear market since the Great Depression than they had been before.
Chances are, your clients less excited about taking market risk now than they were in, say, the early months of 2007, so these results seem impossible. But the FinaMetrica analysts offer a plausible explanation for their results: there are actually three very different components to your willingness to expose yourself to the ups and downs of the market. Two of them changed after the market downturn, and one of those two has recently changed again – at least for U.S. investors.
The first component is what might be broadly called your bravery; your willingness to take chances. This is the part that FinaMetrica measures directly, and its results show that if you were willing to skydive or take ski jumping lessons off the 90-foot hill before the Fall of 2008, you're just as excited by the idea of putting your life at risk now. The markets don't change who you are fundamentally.
The second component is your risk capacity; that is, how much financial risk you can afford to take. The 2008-2009 bear market might have caused a lot of us to rethink how early we might be able to retire, but a reprise of it might make us wonder if we can retire at all. So we become a bit more conservative in our investment approach.
Component number three is our risk perception. If we're watching the markets go up and up and up, then we see little risk and lots of upside. This is why, during the late 1990s tech boom, even the most timid American investors were throwing money into the market like drunken sailors. When the markets deliver the opposite experience, we look at stocks and see nothing but risk.
