The Psychology of Risk

Paul Slovic, a distinguished cognhive researcher we met earlier, has devoted much time to studying the psychological factors that shape judgments of rislf. Research on the psychological perception of rislf shows diat people tend to respond to hazards they perceive. As chapter 10 indicated, psychological studies of flood insurance sales demonstrate that they are heavily influenced by recent experience. Thus, local businessmen will buy more insurance after a flood, when the experience is poignant, than they did, on the same floodplain, before the natural disaster. Similarly, travelers buy more insurance after an airplane crash.

In a panic, investor perceptions similarly can vary on the most clear-cut of investment criteria. Balance sheets, statements of profit and loss, financial ratios-all of which usually seem almost fixed in concrete- can look dramatically different to investors in anxiety-producing conditions. Questions arise in a period of great angst, sometimes valid, but more frequently frightened reactions about the worth of inventories, plants, product lines, and a host of other company variables.

If a PC manufacturer in a period of crisis writes down the value of some outdated inventory, questions are hkely to surface not only about the value ofthe companys inventory but about the entire industry. Balance sheets which have appeared to brisde with strength are now questioned and perhaps challenged, wi± an accompanying drop in stock prices.

Trustworthiness, which has been studied by social psychologists within the domain of 1 1 8 1 perception, also has a bearing here. Credibility has been shown to be hard to acquire (many reinforcing instances are needed to attain it) and easy to lose. As Paul Slovic summed it up, "When it comes to winning trust the playing field is not level. It is tilted towards distrust... ."

Again, looking at risk, our perceptions can run wild on the most feeble of evidence. Companies with cast-iron balance sheets or product Unes can be severely jarred by a minor industry player reporting the need for an upward revision of its reserves or a cash squeeze. First Chicago NBD, for example, lost over a billion doUars in market value when it reported a slight increase in its reserves for bad credit card debt in the second quarter of 1996. Credit cards, considered enormous

riods of uncertainty and crisis. As Im sure will come as no surprise to you, risic is anything but a one-dimensional measure.

money makers, were suddenly viewed with suspicion. How bad were these losses likely to be, could they result in a crisis possibly on par with real estate at the beginning of the decade?

Nervousness continued for several months, although the bank said at the time the increase in the reserve was likely to be a one-time charge, which it was. But coming as it did, when investors were apprehensive about the outlook for financial stocks, the perception of the risk exposure from a minor problem increased dramatically. Psychology then can change perceptions even on matters that normally appear black or white.

In the last few pages, we examined the question of what risks you take investing in a crisis environment. We saw that even the most stable risk measures can, like a trick mirror, reflect a different image to investors under varying psychological conditions. While there is not a simple formula for measuring the risk you might be facing, a combination of the price/value ratios Ive recommended will put you well ahead of the conventional wisdom of the day.

Remember, too, there are many dimensions to risk. It is not volatility alone, the most widely used measure of risk. Volatility caimot take into account crisis, and has other major limitations. The stocks that perform the worst in some down markets may be precisely the ones you want to buy, as my examples made clear.

Next, a more basic question: how to structure your portfolio to maximize your returns over time while attempting to minimize your exposure. Well look at the returns over many decades of stocks, T-bills, long bonds, and other investments for a compelling (and nonintuitive) answer.

An Investment for All Seasons

HO hasnt heard this old saw? If the Algonquian Indians had invested the $24 they received from the Dutch in 1626 in payment for Manhattan Island at 6%, they would have $55 billion today? Or marveled at the sagacity of collectors who in the 1870s paid what seems almost pocket change today-a thousand or two-for Impressionist paindngs, now worth $3 million or $4 million? Awesome, or so it seems until you look at the returns of stocks over long periods.

What is astonishing is that returns on equities surpass just about any other investment. And you dont need the penetrating eye of the collector who can spot the genius of a Degas or a Monet and weed out the hundreds of popular and pricey artists of the day destined for obscurity.

This chapter will demonstrate just how well equities have performed over time. Im not speaking of discovering a Microsoft in the 1980s or an IBM a few decades earlier. Im talking of the returns the stock averages have provided over the years. This is before the sizable extra returns that contrarian strategies add. Equally important to the investor, as I will make clear, is the crucial but litde-known fact that stocks are not a risky investment, if you hold them for a number of years. In fact, they are one of die safest investments for putting away money for your retirement or your childrens education.

Finally, we will see that stocks also keep their value better than almost any other investment through hyperinflation and most other crises. We will also look into using this litde appreciated but well-documented information to build a portfolio for your individual needs.