The Risk of Playing It Too Safe

Note: This article is part of Morningstar's May 2016 Risk Management Boot Camp special report.

One under-discussed risk is the risk of your own behavior: the chance that you’ll make irrational, emotional investment decisions. Morningstar’s director of personal finance Christine Benz talked with financial-planning expert Mark Balasa about that risk. Balasa is a Principal at the firm Balasa Dinverno Foltz LLC.

Christine Benz: I know you are a student of investor behavior. How do you prevent your clients from playing it too safe?

Mark Balasa: Many times the emotional part of their brain kicks in over logic. I'll give you an example. We have a retired client who's a widow, she has six children, and she has saved a fair amount of money, just short of $1 million for herself over her lifetime. Her children have all had difficulty in the job market, so she feels like she has to help all of them.

She has kept her portfolio completely in fixed-income securities, and she refuses to tap into that money to live off of. Instead, 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. She doesn't have anyone to talk to, or to bounce these ideas off of that she can trust.

Many times if investors are isolated--and especially if they're in retirement--they may feel frozen in terms of making investment decisions for themselves, because they are so concerned about running out of money. 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 lifestyles and still leave money for their children.

Benz: So you as an advisor are a sounding board.

Balasa: That's exactly right.

Benz: Do you think that your clients are able to accurately assess their own risk tolerances? Or do you find that clients aren't such great assessors of their own ability to tolerate risk?

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 investors are overconfident. When things are going well, as they did for many years in the early 2000s, people viewed themselves as being comfortable with risk.

And then, along came the Lehman bankruptcy and the subsequent market turbulence, and these investors quickly realized: You know what, I am not such a good gauge of my own risk, because I don't like where I am. That leads investors to make the worst decisions at the worst time. So in March of 2009 when the market was bottoming, people made bad decisions because they couldn’t take it anymore.

When you think of it in that context, a lot of people--not all, but a lot of people--are not good at evaluating their own risk tolerance.

Benz: How do you coach clients in a terrible market environment, such as 2008 and early 2009, when everyone seemed to want to move to cash?

Balasa: Looking back at that timeframe, if you had gone to 5% or 10% cash, it didn't make a big difference to the total return in the portfolio--but psychologically, it was a huge release. Clients felt like they did something to preserve principal.

Benz: The advice of "stay put and don't change anything" doesn't cut it? Balasa: After about five or six months of staying put as the market is going down, that message gets really old. Moving just a little bit into cash served as an emotional release.

But looking at the big picture is really helpful to keep that nervous investor in the market. Step back and run projections and look at numbers for yourself: If you see that you had 150% of what you need and now that the market is going down you have 110% of what you need, that may give you the willpower to stay put. If you had 80% of what you need, and then you have 60% of what you need after the market decline, then maybe you have to make some different decisions.

Benz: Tipping a little bit into cash where it's not going to hurt the return much and looking at where you are versus your goals are two strategies for coping during times of market duress. Would you also recommend tax-loss selling at those times?

Balasa: It goes back to controlling what you can during uncertain markets. You can control your tax liability by 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 that we can't control.