There’s clearly an emotional component to risk management as it relates to loss aversion. In behavioral finance, loss aversion refers to the fact that “losses loom much larger in our psyches than gains.”
Researchers have estimated that losses are twice as impactful as gains -- in other words, a $100 loss is twice as painful as a $100 gain is pleasurable.
Left to their own devices, most investors would do better to focus on minimizing their regrets, not maximizing their potential returns.
Virtus argues that risk management is “actually more a mindset than algorithm” -- losses cannot be averted altogether, but investors can be prepared to recover quickly after the loss has occurred.
“If you’re building an investment framework that doesn’t have a clear conception of risk not just mathematically, but psychologically, you’re going to end up in a bad spot,” said Portnoy. “I don’t think the industry is where it needs to be on this topic.”
Embrace Diversification
In an era where some writers and analysts have declared diversification is dead, behavioral finance argues that a well-diversified portfolio is an effective method for preparing for the unpredictable future.
“The mathematics of diversification and the psychology of diversification are two different details,” said Portnoy. “You shouldn’t have to explain why it’s a bad idea to put all your eggs in one basket.”
Humans desire certainty and stability and have difficulty envisioning the cumulative ups and downs of the market over time, preferring to “see the future in an either/or frame” which leaves them in a search for a “sure thing” in the investing universe, according to Virtus.
Since a sure thing doesn’t exist, the next best solution for advisors is to diversify client portfolios in search optimizing, not maximizing gains – in other words, fulfill the client’s goals without overextending on risk.