[Today’s post is from Crispy Doc, an emergency physician who lives and works in California. We’ve got a short, but sweet article today. It discusses the potential for young investors who started investing after 2008 (and have never experienced a bear market) to overestimate their risk tolerance. We may be raising a generation of hyper-risky investors, but their risk tolerances may be recalibrated when the next bear market eventually happens. This article previously ran on Crispy Doc’s blog in July 2018. -WSP]
I recently posted about a friend whose wife had no tolerance for equity risk based on her negative prior experience watching her parents lose significant value on paper in the recession of 2008.
Ubiquitous commenter extraordinaire Gasem (who wrote a highly-regarded guest post on home schooling for this site) noted the false dichotomy that equities connote risk while cash, bonds and CDs are risk-free. He highlighted the fact that the latter, allegedly safer investments are unlikely to keep up with inflation over time, eroding their purchasing power.
Fellow blogger Xrayvsn followed with an insightful comment that posed the following deep thought: If the recession has produced a generation of investors who are overly conservative for having been “once bitten, twice shy,” perhaps the post-recession bull market is creating a generation of investors who, never having been bitten, are overly aggressive in their asset allocation.
For lack of a better name, let’s term them Generation DK after the Dunning-Kruger effect. Recall that Dunning and Kruger described a cognitive bias where someone with low ability and excessive self-regard thinks himself to be a high performer and lacks the insight to perceive his shortcomings. These are the D students who rate themselves as A students when asked.
While not all young investors are bound to overestimate their confidence and assume excessive risk by virtue of their youth alone, data demonstrate that willingness to take risk declines with age. It’s not that millenials are more irresponsible than their elders – they are simply younger. Conversely, irrespective of experience, simply being older is associated with a reduced acceptance of risk.
You appetite for risk will mellow, just as surely as you will someday hike your shorts up to your nipples and suggest meeting friends out for dinner closer to 5PM.
William Bernstein is fond of saying that the young investor at the start of his career should pray for a bear market. Dr. Bernstein’s logic is that such an investor would benefit from pouring in money when stocks are being sold at a steep discount, far from the time when he will need to withdraw this capital, so that the eventual market recovery slingshots his accumulation phase forward with a nice boost.
What would happen if a young investor, high on the self-righteousness of having read personal finance blogs, decides to invest solely and completely in 100% equities, and places all her invested chips in a single total market index fund like VTSAX? Let’s say she has the misfortune to start investing in 2006, and proceeds to see her assets nearly halve their paper value.
A potential positive outcome from this scenario is that the young investor benefits from learning from her mistake when she stands to lose more gastric contents than capital. Two year’s worth of investments are a pittance to pay in the grand scheme of things, she gets a better sense of her true risk tolerance, and adjusts her asset allocation accordingly when she had $20k invested instead of waiting to learn that lesson when she had $2 million invested.
Perhaps, then, there is less to fear from an early hyper-aggressive investor who loses money.
It’s the hyper-aggressive investor who started investing in 2008 and has not felt the paws of a bear market rip through their self-esteem that poses the greatest threat to the future. Some fraction of of those investors are likely to attribute their fortune to their personal prowess: Generation DK. I’ll be curious to see if these folks materialize, and if they’ll become the next generation’s equivalent of the mortgage crisis.
Maybe it’s the recent trip to Greece talking, but the principle of hubris still carries weight these several thousand years later.
I remember during the “dot-com bubble” meeting several young “day traders.” They were trading from home (a big deal then) on their new laptops and had lots of free time to hang out and spend freshly earned cash. They all thought they were market geniuses. I spent my days slaving away at the hospital and wondered how come I wasn’t as smart as these guys. They’ve all disappeared back to humdrum jobs…
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It’s the time in the bull portion of the cycle when people get cocky. It’s always been easy so it must be your prowess. The common anecdotes are Andrews day traders or in the Great Depression stock tips from paper boys.
‘There is nothing new under the sun…’
I do think that there will be a lot of newer investors in this generation who will credit the gains made to their skills rather than a long bull run and will have their eyes opened with the first real bear market.
Long term investors are not entirely immune if they suffer from FOMO and deliberately deviated from their investment policy statement to “cash in” on the run up in equities
I have been thinking about this issue a lot. Part is that I am just getting older, although my pant waist is still anchored firmly below my belly button. However, I also think absolute numbers play a big role. I was invested through 2000 and 2007/8 and it didn’t phase me. Not because I had nerves of steel, but because I had a small portfolio. Seeing a percentage means one thing – especially if a percentage of a small portfolio. Seeing you’ve lost a million dollars is different, even if the same percentage. Real numbers are easy for me to equate with how long it took to make it in the first place. Pokes my emotional inner Hulk right in the eyeball.
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