Understanding Individual Differences in Risk Appetite within Investment Teams
Objective risk is fact-based. It’s the mathematical chance of something happening. Base jumping is risky. Subjective risk is based on someone’s perspective. A superstitious person may decide that flying on Friday 13th is too risky.
“Tell me your approach to managing risk in your investment process”, is one of the first questions I ask a Portfolio Manager. Using a Socratic approach and therefore challenging the accuracy and completeness of thinking, we often arrive at some greater clarity on the subjective risk rules they possess.
However it constantly surprises how this clarity rarely references a PM’s own propensity to feel comfortable taking risk (or not). In fact, it is very rare to find this level of self awareness in professional risk takers!
Opportunity dances with those on the dance floor! So is risk-taking a personality trait ?
A recent research study on over 1500 participants by the University of Basel and the Max Planck Institute for Human Development in Berlin, suggests an individual’s propensity to take risks remains stable over time. The findings have been published in the journals, Science Advances and Nature Human Behaviour.
“Our findings indicate that risk-taking propensity has a psychometric structure similar to that of psychological personality characteristics. Like the general factor of intelligence, there is also a general factor of risk preference”, said Dr. Renato Frey from the University of Basel.
Ok, so is there a reliable assessment tool to help identify this risk preference?
It turns out that The Risk Type Compass, created by Geoff Trickey at Psychological Consulting Ltd (PCL) in the UK is such an assessment.
Geoff states, “The conclusion of Dr. Frey that “risk-taking propensity has a psychometric structure similar to that of psychological personality characteristics”, is a formidable confirmation of the basic rationale of the Risk Type Compass (RTC). It assigns people to one of eight segments in a 360 degree spectrum of risk dispositions, each designated as a distinctive Risk Type.
He adds, “The Basel research reinforces the findings from more than 15,000 administrations of the RTC and the numerous validation studies undertaken in a wide range of industry sectors by PCL. Realisation that risk dispositions are an intrinsic part of personality, rather than just a correlate of personality, are confirmed by the fact that the RTC item themes were drawn from the Five Factor Model of personality”.
When coaching active investors, I have used RTC and found its impact, particularly for investment teams, to be extremely enlightening. Risk Type Compass focuses on differences in the way individuals perceive, react to and manage risk, as well as how they make decisions.
Liking someone in your investment team is good but understanding someone in your team is a requirement.
By understanding more about their natural skills, capabilities and blindspots, investors are able to determine the parts of their process that work with their personality and avoid those that create stress and sub-optimal performance.
As mentioned, there is a crucial distinction to be made between objective and subjective risk. The financial world is well-versed in the former but not in the latter. The possibility of identifying and reliably measuring the distinctive risk dispositions of any individual, contributes to a potent framework within which to manage human factor risk.
Diversity of risk dispositions or often the lack of such diversity within any team or firm, is a potential problem if not recognised, and a potent differentiator when it is.