Hardwired to be risk averse

Rory Maguire

Rory Maguire

It is reasonable to assume that if our ancestors heard a rustle in the grass they should behave as though it were a predator – in spite of it almost certainly being something harmless.

That is because the downside of making the decision based on probabilities is that they could end up dead. Risk aversion is hardwired into our nature, and for good reason.

We see this play out in investing, where it is almost totally counterproductive to trust these same instincts.

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There is lots of academic work on this, particularly by the psychologists Amos Tversky and Daniel Kahneman.

Take an example – if you offered investors the chance to have either £1,000 or a 50 per cent probability of £2,500, most people would reject those odds and prefer the more risk-averse £1,000.

In financial terms, that likely means a client will end up in a bond or cautious fund, when what they need is something more ‘risky’ but with better rewards.

This risk-first meme is exacerbated by the culture of fear and compliance we are seeing in the marketplace, too.

Risk profiling and attitude to risk questionnaires are so dominant and are crucial inputs into the asset allocation each client eventually ends up with.

These questionnaires involve so many ‘risk’ questions, each ratcheting up the anxiety levels. And this when the software in our brains is already predisposed to making us risk averse.

We ask: are clients more worried about losses after the questionnaire or before? It is a stupid question, of course. Instead of balancing our predisposition to be risk averse, these questions only amplify our irrational anxiety.

Equally culpable is a regulator that is also driving risk aversion. It is clamping down so heavily on advisers that it results in the scary notion of the adviser being liable for losses way beyond the point at which they retire.

So the adviser, too, may be incentivised to suggest a cautious or bond fund ahead of an equity product. Who ever got sued for protecting capital?

For now, the low-risk virus has been hidden from view by a market anomaly that is arguably a once-in-a-generation phenomenon. Low-risk assets like bonds have delivered exceptional returns, so investors choosing cautious or bond funds have done remarkably well.

Who would have thought that across 10 years (and indeed one and three years), ‘risk-free’ assets such as gilts would have beaten the FTSE All-Share?

Our point is this: the low-risk virus is at work among savers; we think the average service provider probably make this worse, as does the FCA. Given we are already risk averse by nature, do we really think the best way to achieve a balanced view is by asking lots of questions about risk appetite?

So, should we all invest in equities? Of course not. But, equally, when we see a statistic like 78 per cent of our Isas are ending up in cash, with only 22 per cent in the stocks and shares variant (2014-15 tax year), it should stop us in our tracks.