A study comparing investors’ risk tolerance with the Consumer Sentiment Index (CSI)—a measure of the consumer outlook on the U.S. economy, including employment and inflation predictions—found that risk tolerance and the CSI are positively correlated. Investors’ risk tolerance decreased as the stock market faltered.
In other words, as the outlook on the economy improves, investors are more risk tolerant, and as the economic outlook appears grim, risk tolerance decreases, according to “Do Large Swings in Equity Values Change Risk Tolerance?”
This has interesting implications for retirement plan sponsors because it can deliver some insight into how plan participants make investing decisions. “The most harmful thing investors do is sell low,” says Michael Finke, a professor of personal financial planning at Texas Tech University and co-author of the study.
In mutual fund performance, this is known as the dumb money effect, Finke says. “Investors tend to pile into the sectors that have gone up the most, and pull out from those sectors when values fallen,” he tells PLANSPONSOR. Stock mutual funds in the first three months of 2009 showed record net outflows of $20 billion each month, according to Finke: “About the worst thing they could have done.” Investors who left their money in equities instead of pulling out at the wrong time recaptured two-and-a-half times their original value, he says.
The study’s co-author, Michael Guillemette, an assistant professor of personal financial planning in the University of Missouri, notes that while risk tolerance followed trends in the stock market, it did not change as much as the stock market. “So when the stock market dropped by about 50% during the recent global financial crisis, risk tolerance dropped by about 7%,” Guillemette says. “What this tells us is that risk tolerance is very dependent on the traits and personalities of each independent investor.”
Age also plays a part in investment decisions, Finke says. “The older you are, the more likely you were to pull money out during the 2009 recession,” he says. The reason is not nearing or being in retirement, but cognitive decline.
In cases where cognitive decline is measurable, Finke says, people are more likely to avoid risk, and to pull out of stocks. In 2009, he says, cognitive decline accounted for some investors pulling out of the equities market. Once a person begins to make poor decisions, it is reasonable not to take on as much risk, but the decision in 2009 turned out to be a very poor one, he says.
Another finding of the research is that advisers who create portfolios based on risk tolerance assessments tend to keep their recommendations more conservative during a recession than in an economic expansion—information plan sponsors should be aware of, since plan participants may end up with more conservative results following a market decline. “If you recommend a conservative portfolio when equities are cheap, you risk exacerbating these long-run individual investors’ underperformance that we see from bad market timing,” Finke says.
Plan sponsors can use this information in participant education. “Providing some sort of guidance in bear markets might help employees maintain a focus on their long-run objectives,” Finke says.
Finke feels that most employees can turn to target-date funds (TDFs) as a way to avoid this particular loss. “The best thing that’s happened in the defined contribution world is the movement toward TDFs as a default investment,” he says. “Because they are self-rebalancing products they will prevent much of this investor loss.”
TDF use has certainly skyrocketed, Finke observes, pointing to data that shows about $50 billion invested in TDFs in 2007, and more than $500 billion in TDFs last year. “My perspective is that they help reduce some of the losses from these biases,” he says. Investors can still make changes to their accounts, but they are less inclined to when they have their money in a product that automatically rebalances.
The study also found:
- Average monthly risk tolerance scores increased as price/earnings ratios increased, and decreased as dividend yields increased. Respondents became less risk tolerant as equity valuations became more attractive.
- Average risk tolerance scores demonstrated little monthly variation, despite large swings in equity values during this time period. This suggests that individual risk tolerance scores are determined more by individual preference than external market forces.
“Do Large Swings in Equity Values Change Risk Tolerance?” is available in the June issue of the Journal of Financial Planning.