Combatting Risk Aversion in Active Portfolio Management
We finally have a tool that helps us change our ancient habits.
Since the dawn of humanity, people have instinctively chosen safe options over taking risks. These decisions, while sometimes limiting, likely played a crucial role in our survival, allowing us to thrive over the ages.
However, the same neurocognitive processes that kept us alive in the wild now limit our investment upsides and often lead to painful downsides. We are faced with a new modern challenge with our risk aversion.
Risk aversion is deeply rooted in our decision-making processes, guiding our choices automatically and rapidly as our “default setting.”
Researchers characterize this as “risk as feelings,” finding that our innate risk aversion informs how we feel about taking risk. The catch is that it isn’t well-tuned to cope with risky financial situations without significant training. Similarly, taking excessive risks occurs when investors (and gamblers) are in losing positions and fall prey to loss chasing.
It’s a difficult truth to hear that we shouldn’t trust our gut when it comes to financial decision-making, but the reality is that our natural tendencies often lead to losses.
Risk Aversion in Everyday Investing
It’s not just in active investing that risk aversion wreaks havoc on our lives:
- We stay in cash because we’re afraid of or feel like we don't understand the stock market.
- If we do invest, we buy safe assets because we’re afraid of "volatility."
- If we buy risky assets, we sell winners too soon as the price goes up, or we panic when the price drops and sell too early.
The list goes on, but the good news is that behavioral technology can increase your wealth by helping you make better decisions.
Overcoming Risk Aversion in Active Portfolio Management
“Many people choose excessive safety and miss opportunities to grow their wealth.”
Overcoming automatic risk aversion takes effort, but the reward is well worth it. That reward is the ability to distinguish automatic, often damaging choices from constructive, profitable ones—and act accordingly, regardless of how it feels.
Risk aversion manifests in many forms in active portfolio management, with the most easily detectable being the premature selling of winning stocks without a solid economic rationale. Another common issue is the over-selection of low-risk assets.
While it’s essential to invest according to your risk capacity and appetite at each stage of life, many people choose excessive safety and miss opportunities to grow their wealth. The following are key ways missed opportunities can happen:
- Being reluctant to add to an excellent investing opportunity out of fear of allocating more capital and increasing Average Cost Basis (ACB)
While people feel compelled to buy more of an investment when it falls below their ACB, many investors feel fearful and hesitant about buying more of an asset after its price increases (also known as “averaging up”). - Underweighting an investment
This is a subtle form of risk aversion where the investor doesn’t commit enough capital to a potentially profitable opportunity due to fear. - Overreacting to price changes
This is when an active investor panic sells below the asset’s fundamental value due to a rapid price drop only to watch the price recover afterward.
Doing Nothing is an Active Choice
Even though NVIDIA was one of the biggest winners of 2023 and 2024, it was also the biggest loser in a hypothetical “Invisible Portfolio” where it was held instead of sold prematurely.
This mistake stung, but it taught us a valuable lesson, leading to the creation of a fintech venture focused on helping investors separate behavioral impulses from economic decisions. Fast forward to late 2024, and we see the positive outcome of avoiding a similar mistake, thanks to SmartTrade.
Let’s take a deeper look at how this positive outcome came to be.
We were interested in a Canadian firm called VitalHub (TSX: VHI) in March 2022 after reviewing their financial statements and business plan (reminder: this is not investment advice or a recommendation to buy/sell/or hold VitalHub). We bought shares and decided to "watch the story play out" over time.
When the price started ramping up in November 2023, our first instinct was to sell immediately to lock in gains and go to cash—classic risk aversion-driven selling. However, remembering the painful and unnecessary NVIDIA selloff ten years too early, we used SmartTrade to help us manage the risk aversion.
Instead of selling due to discomfort from the price increase, we entered a SmartTrade for a "Hold" decision twice. It worked. Here’s the behavioral upside of actively “doing nothing” in this case:
- We felt better about our fears by expressing them and standing in the discomfort without acting on them destructively.
- The price continued to appreciate drastically, hitting all-time highs repeatedly (reaching $8.74 on August 9, 2024).
- It affirmed our belief that we can learn from our mistakes and improve over time with the help of behavioral fintech.
Key Takeaways for Combatting Risk Aversion When Investing
- Investing requires more than just picking "winners"; we need guidance and support to handle the inevitable ups and downs.
- Most investing mistakes are avoidable if we understand what triggers them.
- Behavioral fintech is the best tool we have to rapidly improve as investors and increase our wealth by generating behavioral alpha.
We are launching a platform that will allow investors to visualize their own trading patterns and take advantage of behavioral insights. If you’d like to be added to the waitlist, please click here to sign up.
Invest Smartly,
The Prof of Wall Street Team
