The Unwealthy Barber.
The barber that cuts my hair has a hot stock tip.
A diamond mine. A ‘sure bet’.
We’ve all heard this one before.
My barber doesn’t recall the name of the stock. She hasn’t read any research on it. She’s not sure where it is exactly. And the source of this stock tip is the barber two chairs over. (I couldn’t confirm this because ‘the source’ only cuts hair part-time – presumably because he’s so successful investing in his own stock tips).
And ‘what do I think’?
How does one get Individual investors to (at least) consider risk rather than focus on returns only?
In his book “Upside Downside – Simple Rules for Risk Management”, Dr. Ron Dembo, says that “Even though our financial security is crucial to our well-being, we take risks with our money that we would normally not take”.
Very few Individual investors consider themselves to be gamblers, but some investment risks they take with their money simply don’t make sense. Buying a diamond mine based on rumour from an unsubstantiated source and without further research is like taking ones retirement money to the casino and betting it all on red 23.
Dembo suggests that one way to look at risk is to “anticipate regret”. This means (‘before’ you invest) analyze an investment in terms of how much regret you might experience should the investment fail. This helps an investor avoid taking thoughtless risk. Risks investors do take become calculated and these are “least likely to cause grief”. The riskiest decisions might cause the most regret.
The benefit of this framework is that it analyses risk in behavioral terms rather than traditional risk-return analysis. “Envisioning regret” automatically incorporates the investor-specific financial situation (can I absorb a loss?), personal risk tolerance (what’s the emotional impact of a loss?) as well as long-term goals into the decision-making process for each investment. So investor focus moves from ‘returns only’ towards ‘return potential given the risks’ – where the focus should be.
For my barber, a loss from this bet (and, make no mistake, it is a bet. And not a good one.) would significantly impact her long-term financial health and that of her two young girls whom she is raising alone. Recovery could take years. She may never be able to recover.
Is my barber a risk taker? Nope. A loss would cause her significant financial and psychological distress. Does this sound like money this investor should take to the casino? It isn’t. It’s money that helps to meet the family budget.
Dembo says, for a bet to be a good bet, the upside has to be more than the downside.
The worst case scenario for this diamond mine bet is a 100% financial loss. But then there is the devastating emotional loss. Is it worth the risk? No.
This scenario is an all too common challenge for too many Individual investors. How does one help to ensure future financial security by being prudent (some would say boring) and yet satisfy the urge (or need) to occasionally gamble … or take a flyer now and again?
How about buy Royal Bank stock and, with the dividends, buy the diamond mine stock?
Or quit smoking and use the money to instead buy a lotto ticket?
Or, with the dividends from Royal Bank stock (or money saved from not smoking) buy a ticket for a meat draw at the local Legion or next Lodge fundraiser. (The beer is cheap too)!
Dembo’s upside? My barber could own Royal Bank stock (and the dividends) for the rest of her investing life. If the diamond mine (or the lotto) pays off, she could buy more Royal Bank. Maybe even some for her girls.
Dembo’s downside? My barber could own Royal Bank stock (and the dividends) for the rest of her investing life.
And she can live with that.
Doug Cronk CFA is Manager, Investments for a Canadian Pension fund.