The Risk of Playing It Too Safe

Note: We are refeaturing this video as part of Morningstar.com's November 2014 Risk Management Week. This video was recorded in June 2010.

Christine Benz: Hi. I am Christine Benz for Morningstar.com. One under-discussed risk is the risk of your own behavior, the chance that you'll buy high and sell low. Here to discuss that risk for us today is Mark Balasa. Mark is a Principal at the firm Balasa Dinverno & Foltz. Mark, thanks so much for being here.

Mark Balasa: My pleasure.

Benz: So, Mark, I know that you are a student of investor behavior, and one thing I'd like to talk to you about today is, how you are helping clients not play it too safe in this environment? So we went through a traumatic bear market where people really did have to change their lifestyles in the wake of the money they lost. How do you talk to people about the risks of playing it too safe, which is where their comfort level might be?

Balasa: Great question. It's a tough environment for a lot of people as you just described and so for them many times the emotional part of their brain kicks in over their logical parts. So I'll give you a quick example of someone – a client of ours that came in actually, not even three weeks ago. So she comes in, she's a widow, she has got six children, and she has saved a fair amount of money, just short of $1 million for herself over her lifetime. Again, she's widowed, and her children have all had difficulty in the job market this last 18 months or two years, and so she feels like she has to help all of them.

So, her portfolio, she has kept it completely essentially in fixed income and she refuses to tap into that money to live-off of--she's living off of just social security and a very, very small pension, because she's absolutely paranoid about running out of money and not being able to leave the children anything. Because she doesn't have anyone to talk to, bounce these ideas off of that she can trust, she won't, for example, upgrade and do some very basic things for the house, like in the kitchen, to make it more livable.

So I think many times the person is isolated and especially if they're in their retirement age or even further into retirement age, they feel frozen in terms of making investment decisions for themselves in this environment, because they are so concerned about running out.

So I think if someone can give them or if they can for themselves look at some numbers and get a bigger view of what that money will mean to them, they can improve their lifestyle and still leave monies for the children and some more other things that are important for them in their life.

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Benz: Right. So you are sounding board and I assume right now you are talking about the risks of having too much in the safe stuff, because you really need your assets to grow and you can't grow at 0.25% per year or whatever cash is…

Balasa: That's exactly right.

Benz: So another thing I wanted to talk to you about is clients' assessments of their own risk tolerances. Do you find them useful in terms of crafting a portfolio or do you find that clients aren't such great assessors of their own ability to tolerate risks, what's your take on that?

Balasa: In general, I think investors are challenged at evaluating their own risk tolerance. And one of the basic tenets of behavioral finance is the idea that human beings, investors, if you will, are overconfident. And so when things are going well, as they were for many years in the 2000s, starting 2002, let's say, going forward, people got very comfortable with risk, and they viewed in themselves of being comfortable with risk.

And then, along comes the Lehman bankruptcy in the following six months and they quickly realized that, you know what, I am not such a good gauge of my own risk, because I don't like where I am at, which leads them to making the worst decisions at the worst time. So in March of '09 with the markets bottoming, people are making decisions that I can't take it anymore.

So when you think of it in that context, a lot of people, not all, but a lot of people are not a good gauge of evaluating their own risk tolerance.

Benz: So how do you coach clients, then, in a terrible market environment like '08 and early, '09 when everyone's wanting to move to cash, do you give into that tendency or how do you fight against that at a time like that?

Balasa: It's a varied answer to your question. Our clients looking back at that timeframe, if you let them go to 5% or 10% cash, it didn't make a big difference to the total return in the portfolio frankly, but psychologically, it was a huge release. They felt like they did something to preserve principal.

Benz: So saying stay put, we're not going to change anything doesn't cut it?

Balasa: After about five or six months of seeing staying put as the market is going down, they get really old. And so this was kind of an emotional release. But for most people, if you can step back and if you run projections, again, coming back to the idea of looking at numbers for yourself, if you see that I have a 150% of what I need and now the market is going down, I have a 110% of what I need. It gives you the ability to stay.

Now, if you've got 80% of what you need, and I have 60%, but then maybe you have to make some different decisions. But again, coming back and looking at the big picture is really helpful to keep that nervous investor in the market.

Benz: Right. So tipping a little bit in the cash where it's not going to hurt the return too much, looking at the numbers, looking at where you are versus your goals, anything else, so it was tax-loss selling perhaps, something that you did?

Balasa: Well, it was. It goes back to some of the things as you are suggesting that you can control. So you can control that your tax liability, get harvesting losses. You can minimize expenses, you can save more. You can work longer. These are all things that you can control to help offset many of the things in life we can't control.

Benz: Okay. Thanks, Mark, helpful insights.

Balasa: My pleasure.

Benz: I appreciate it. Thanks for watching. I'm Christine Benz for Morningstar.com.