The Skewness of Risk Tolerance

"The length of this document defends it well against the risk of being read." - Winston Churchill

"Only those that risk going too far can possibly find out how far one can go." - T.S. Eliot

Risk tolerance is a very interesting topic as it is embedded in the psychology of trading and investing.  There are numerous studies done on the topic but what is often missed is the change in risk tolerance with the returns of the market.  Investors can be placed into buckets by risk tolerance.  In the first bucket are the conservative investors that never earn a large rate of return but are relatively well protected during years where the market performs poorly.  In the other bucket are the high risk investors that press the envelope in an effort to beat the indices and make a large profit in a short amount of time.  Now obviously each bucket has a very different risk tolerance but as a group this can swing from more risk to less.

When the market runs (as it is now) these high risk investors sway the risk tolerance of the overall group towards the high risk spectrum for the simple reason that their net worth moves up far faster than the conservative investor (not to mention that a lot of conservative investors jump across buckets as they hate to be left behind).  This group therefore commands a greater portion of the market raising the overall group's risk tolerance.  When a market correction occurs these investors lose far more than the conservative investor and so the group's risk tolerance retreats to a lower level when markets are down.  Looking at this from the theoretical window it is easy to see the fallacy of their ways as quite clearly investors should have a higher risk tolerance after a market correction whereas in fact the opposite always occurs.

As an example look no further than Brazil where Batista the Brazilian billionaire has seen $34.5 billion wiped out in a matter of months.  The reason is that in order to make $34 billion in a lifetime you have to take on enormous levels of risk.  Now while most billionaires start to pare down their risk levels once they achieve levels such as these, Mr. Batista thought of himself as a superhero and continued pushing the envelope until finally everything fell apart at the seams.  Worse still is that he had managed to suck in seasoned investment professionals such as Pimco, GE, Blackrock and Abu Dhabi's sovereign wealth fund to name just a few high profile investors.  Shows you what a fast boat, fast cars and playboy models can do!  It also shows you that often times following the supposed "smart" money is not the answer.

Looking at the market today it is clear that the risk tolerance levels are reaching very high levels.  The signals are easy to spot; margin levels are at all time highs and market volatility is high while investor perception of risk is low.  Margin refers to money borrowed by investors to finance additional stock purchases.  Essentially the broker lends you money to add to your positions meaning that you take on ever more risk as every move in your portfolio magnifies the returns or losses.  Risk perception as measured by the VIX shows a complete disdain for risk even in the face of the stalemate in congress.  The reason that this fear is low is that investors after four bouts with similar congressional stalemates and debt ceiling raises have put the whole thing down to political posturing and are ignoring the seriousness of the outcome.

This is worrying from many levels but to me the market complacency is a signal that while investors believe that the outcome is inevitable (and it certainly seems like it is) if there is a change in perception another October crash could be in the works.