Result of Overestimating & Underestimating Risks

As investors, we are generally guilty of two things:

1. Underestimating risks
2. Overestimating risks

And the result in both cases is fairly obvious:

1. Underestimating risks – can lead to losses (at times huge)
2. Overestimating risks – can lead to missing out on profits (at times huge)

Let’s talk about both aspects in some detail:

Underestimating Risk

Underestimating risk that eventually becomes a reality, can lead to losses. This is a no-brainer. For example – in late 2007, there were obvious risks to market due to various factors (like credit crisis, overvaluation, etc.). Party continued for some more time but when it ended, it had a long list of casualties. All these factors are obvious in hindsight but that’s how it is.

In investing, underestimating risk can trick investors into believing they can tolerate far more downfall than they actually can. But when the risk comes home, people panic and are psychologically arm-twisted into decisions that can cause substantial losses.

Overestimating Risk

This is common too. At times, we exaggerate and go well out of our way to avoid risks… even those with very low probability. This obviously comes at a cost, i.e. sacrificing a chance to earn decent rewards.

For example – Between 2015 and 2018, if someone was basing their decision on just one parameter like (let’s say market PE) and getting obsessed with some sort of framework induced blindness, then that would have cost them some profits. Nifty hit PE24 (considered to be pretty high) on 3^rd March 2015 (Nifty was 8996 that day). A clear sign that things had begun to overheat. But what happened next? Nifty (on 29-Jan-2018) is at 11,130 at almost PE28. So had that investor who was blinded-by-the-one-factor framework decided to exit equity completely at PE 24, he would have missed out on this 25% upmove after that.

Ofcourse this episode is yet to play out fully (unlike 2007-2009 which is known to us in full).

Timing the markets is difficult if not impossible. But that’s not the topic of discussion here. What I am trying to highlight is:

We oscillate between underestimating and overestimating risks. We misunderstand it. We mistreat it. But as investors, we have to live with it.

For most people, it’s not possible to take all-in or nothing-in kind of bets in investing. Unless they are really smart investors who have insider info at multiple levels and what not… 🙂

What to Do?

Our assessment of investment risk plays a big role in helping or hindering our overall investment returns. So we need to balance and manage the risk that we take. And mind you it’s a delicate balance… more so towards the extreme ends.

Realistically speaking, we will continue to overestimate and underestimate risks. And being humans, we will always have some level of anxiety about the risk we are taking or about the risk ‘we think’ we are taking. That is a normal thing to feel.

With that said, our agenda should be to ensure that we don’t go too high or too low in our estimations. We must absolutely leave room for doubt, luck and for unprecedented (if not black swan) events.

Miscalculations to some extent are fine. But beyond those thresholds, it can cause a lot of pain – for losing out the invested capital (when underestimating risk) and losing out on possible profits (when overestimating risks).

I personally feel that ‘risk’ is a powerful ally which can help us build a lot of wealth over the long term. We need to understand and manage it. It’s a great friend if it’s working for you and a terrible enemy if working against you. And to be fair, irrespective of whether it’s a friend or an enemy, it will periodically test your patience and mental strength. 🙂

At times, we go wrong with our estimation of risk due to lack of prior knowledge about market history. And at times, due to over-analysis of data that at times may lead to statistical discoveries favoring our pre-conceived notions. We need to be aware of both these vulnerabilities when managing our portfolios.

So what exactly should be done if we cannot assess the risk perfectly or time the markets perfectly?

There is no easy answer here. But few things are pretty clear:

We need to have a proper portfolio strategy in place that is in line with our risk appetite. We need to maintain vigil. And if our skills (or advise taken from smart investment advisor) permits, we ‘may’ take tactical calls to tilt our portfolios to benefit from certain situations. This is about smart and adaptive asset allocation. I will write about this in more details some other time.

This post was more about highlighting how misjudging risks which is a common occurrence can jeopardize the health of the portfolio. This in turn can reduce investor’s ability to attain desired financial outcomes.

With markets doing well, maybe it’s a good time to look inside and contemplate about the risks you may or may not be acknowledging.