Sunday, September 27, 2009

How Conservative Are Investors?

This is a Sunday feature looking back at selected articles from the early days of this blog before readership had ramped up. Enjoy.

Everything I read about asset allocation says that investors are very conservative and must put a significant fraction of their money into fixed income investments like bonds even though stocks have historically given much higher returns.

All of these commentators may be right about their assessment of investor psychology. Of course, this says nothing about what would be best for investors; it is just a reflection of how investors think.

Morningstar has formalized this view of investors in a formula for assessing investments called the Morningstar Risk-Adjusted Return (MRAR). All the math in the Morningstar explanation tends to obscure what is going on. Lets look at a simple example. Suppose that each year a particular investment either returns 50% or loses 20% with equal probability.

A simple view of this investment is that its average return is (50%-20%)/2 = 15%. Morningstars MRAR calculation can handle different degrees of conservatism, and this simple kind of average corresponds to MRAR(-1).

Another way to look at this investment is that after two years you will probably make 50% once and lose 20% once. So, $1 would grow by 50 cents to $1.50, and then lose 20% of $1.50 (30 cents), leaving $1.20. The two-year return is 20%. This corresponds to an annual compound rate of 9.5%. After many years, the odds are about 50/50 whether your long-term annual return would be above or below 9.5%. This kind of average corresponds to MRAR(0).

You can think of the drop in return from 15% to 9.5% as a penalty for volatility. And this high penalty is appropriate. This is a very volatile investment.

But Morningstar thinks that the volatility penalty should be much higher than this to match the risk tolerances of typical retail investors. Im not sure, but I think retail investors is a reference to dolts like you and me. Presumably, professional money managers have different risk tolerances.

Morningstar says that the typical investor is so conservative that we should use MRAR(2), which labels our hypothetical investment with a risk-adjusted loss of 0.2%! If Morningstar and other commentators are right, investors would rather stick their money in a zero-interest bank account than go for a 50/50 shot at either making 50% or losing 20%.

Maybe most investors really are this conservative, but Im not. I make sure that I have adequate cash reserves, and have safe investments for any money I will need in the next three years. After that everything is invested for the long term, and my risk tolerance is consistent with MRAR(0).