I will risk embarrassing myself to help illustrate why risk budgeting is a valuable service that CLS provides for our clients.
As a neuroscience major in undergrad, I learned that the reasonable, logical part of the brain is not always in charge. Even worse, I learned that because of limitations, the brain does not always perceive the world as it is. Look at the image below and tell me which orange circle is bigger.
If you guessed the one on the right, you are wrong; they are the same size. The brain uses what are called heuristics, also known as rules-of-thumb or shortcuts, to process information, which explains why illusions such as this occur. They also explain why humans are poor at assessing risk and predicting the future. Certain rules-of-thumb, like projecting the past into the future occur automatically, but can be fallible when considering investments.
Another issue with the brain’s ability to deal with risk has to do with its evolution. The neocortex (“new” cortex) is a recent development. It is the outside portion of the brain that folds in on itself. From it arises logic, reason, planning and imagination. An older portion of the brain called the amygdala is the source of emotions such as fear and anger (that’s right Bobby Boucher, it’s not the medulla oblongata). This portion of the brain played a critical role in helping humans develop the fight-or-flight response by helping them associate danger with fear, and then act. This portion of the brain has a significant impact on the neocortex and influences behavior. An embarrassing story from my past will illustrate this point. When I was about six-years-old, my siblings and I caught a lizard and took it home to show my mom. Somehow the lizard manage to escape. I soon forgot about our cute little friend and started filling up the bathtub to take a bath. I checked that the water was warm enough, stripped down and, without taking another look, sat down. Unfortunately, the lizard decided to take a bath too and slipped in while I was not looking. I am sure you can imagine what happened next. He was probably more scared of me than I of him, but I screamed bloody murder and leaped out of the tub. Thankfully, I am no longer scared to take baths, but I have never gotten over my fear of lizards (and snakes). My amygdala formed a powerful association that day, while not as acute now, it still lingers after all these years.
CLS offers a disciplined risk budgeting methodology that takes the emotion out of the process.
The risk score of an asset is what it is. We do not argue with it or let emotion, including fear, impair our discipline. As long as the client entrusts us, we will make sure that the risk of their portfolio stays in line with their goals so that the amygdala or heuristics do not get in the way of sound investing.
Comments provided by guest writer Matt Chadwell, CLS Portfolio Analyst