Risk Aversion and Decision Traps

Great article covering risk aversion and how the typical investor reactions and makes the wrong decision. This is a time to be buying great companies selling at a discount. The American public loves sales; well the market in on sale. PG selling at 60 is an example of a great company selling at a discount. It is surely cheaper than it was just 12 months ago, but still providing the same revenue and earnings growth. Financials are another issue; time is needed to determine who is going to survive. Mr. Greenspan left Mr. Bernanke a mess to clean up.
Review our website in the coming months as we cover ‘Eight Common Decision Traps”. We are working in concert with a local university to communicate the traps and provide tools to overcome them.

Risk Aversion
By Felix Salmon
Source: Seekingalpha.com, 8-8-08

I've been thinking a bit more about the downside of risk aversion, which is something that Steve Waldman, brought up yesterday and which I then applied to the ARS fiasco, among other things. The problem is that it's entirely natural, even when it isn't a good thing, and so I've been wondering a little a related question: given that risk aversion has always been around, how has capitalism dealt with it in the past?
Recall that it was too much risk aversion (it even had a name: "portfolio insurance") which caused the 1987 stock-market crash. And it's too much risk aversion which causes any kind of liquidity crisis, from a generalized reluctance to lend all the way to an outright bank run.
Right now, investors are really panicky, because they're coming to realize -- quite possibly for the first time -- that there's a large amount of risk built in to all of their savings. If you just kept your money in a savings account, it was historically perfectly safe. But with the dollar collapsing, that's no longer the case. If the world's reserve currency is also a weak currency, what is a risk-averse investor to do? Other stores of value -- buying commodities, or other currencies -- involve increasing your risk profile, so while they might make sense, they're not a great place to go psychologically. And as for the safety of housing, well, the less said about that the better. Suffice to say that it probably would be a safe investment, if it weren't for the fact that it was so highly leveraged.
In many ways, the financial system is actually based on risk aversion. That's why there are more bonds than stocks: with a bond, you're promised your money back, in full, with interest. Stocks have a significantly higher return than bonds, which results in the equity premium puzzle. Even after accounting for risk aversion there's a puzzle there; before accounting for risk aversion, it doesn't seem to make any sense at all to buy bonds rather than stocks.
Risk aversion is so all-pervasive that capital-structure arbitrageurs are never going to be able to make it go away. And as we've seen it extends even unto the very largest investors, entities like the Chinese central bank, with trillion-dollar balance sheets. (Maybe if they hadn't been so risk-averse, buying only US Treasuries and their ilk, they wouldn't have lost so much money when the dollar collapsed.)
Stock-market investors, too, are risk averse -- even those who you might think wouldn't be. I remember talking to a very successful investment banker once, who was being offered downside protection on her stock portfolio by her private bank. Of course, as a successful investment banker, she priced out the product: she went to a friend working in equity derivatives, and worked out how much it would cost to replicate wholesale. But once she did the math and decided that her private bank wasn't ripping her off, she was very serious about buying the product. It's called the endowment effect: Once you have money, you're more scared of losing it than you are excited about seeing it grow.
Risk aversion is a great way of explaining business cycles. When everything's going up, people spend much less time worrying about the risk of things going down. So their risk aversion dissipates, or else it's simply overwhelmed by their fear of losing out on potential upside. Nothing lasts forever, however, and so when the bull market ends, the risk aversion comes back with a vengeance. Things are going down, so worrying about things going down is entirely natural. And there's precious little opportunity cost to playing it safe, either: in fact, the safest investments tend to outperform.
For that matter, risk aversion is also a great way of explaining the success of Warren Buffett. He's an insurer at heart, and insurance companies make their money by insuring people against the risk of loss. He's happy taking big, billion-dollar risks, so long as they're priced correctly. And he loses no sleep when the securities he's invested in fall in value: if anything he likes that, because it just means they're getting cheaper and better value should he want to buy more. The vast majority of us, however, simply don't have the psychological ability to behave like Warren Buffett. (And, of course, Buffett's a multibillionaire with a relatively modest lifestyle whose children will inherit relatively little: he can easily afford his attitude to risk.)
You can't make risk aversion go away: it's hard-wired into what it means to be human. Maybe all we can do at this point is sit back, and wait, and have faith in a higher power. It's called greed.