Risky Investing: What Happens in Vegas Doesn’t Always Stay in Vegas
Over the past few years, the belief (a myth, maybe) that financial markets are governed by the measured, rational behavior of millions of market participants acting in aggregate has pretty much been blown apart. Scientific studies conducted over the past two decades — and anecdotal evidence gathered for much longer — have developed a picture that looks like a family member of Benjamin Graham’s Mr. Market. While the fundamentals are still fundamental, a tremendous amount of market activity can be boiled down to the perplexing and nebulous behavioral traits of market participants, such as taste, intuition, and risk tolerance.
It is this last aspect — risk tolerance — that is the focus of a recently released paper by Chi Liao, a Ph.D. candidate at the University of Toronto’s Rotman School of Management. The paper helps shed some light on one of the factors that may have contributed to the increased risk tolerance that some feel is prevalent in today’s marketplace.
“The nature of risk taking is fundamental to decision making in the realm of economic choices and beyond,” Liao writes. “Our understanding of risk and risk taking has bearing on every aspect of portfolio design, from asset allocation to asset selection to performance evaluation.”
To a degree, an investor’s risk tolerance is a preference. There is, of course, some poorly-defined baseline level of risk that an investor is comfortable with that informs decision making, but more often investors measure and accept risk in tune with their investment objectives. The objectives of a pension fund, for example, require a strategy that generally accepts less risk than the objectives of a momentum portfolio. A portfolio packed with penny stocks has the potential for large returns, but also faces the risk that the companies it is involved with will go bankrupt. A portfolio packed with blue chips is much less likely to experience a bankruptcy, but does not have the same sort of enormous growth potential.
With this in mind, the majority of investing is done in a way that seeks to minimize risk while maximizing returns, and this is always a game of give and take. What do you want, and how do you get it? If you want returns, you accept risk (this is grossly oversimplified, but it is hopefully still illustrative). Conversely, if you want safety, you sacrifice growth.
Over time, investors and portfolio managers tend to identify and settle into a risk-versus-reward balance that fits their style and objectives. ”Standard models in economics and finance assume that individuals are endowed with stable, well-defined risk preferences,” writes Liao.
“More recently, however,” Liao continues, “studies have shown that risk preferences do not necessarily behave as previously assumed and can, in fact, vary throughout an individual’s lifetime.” Things that can impact a person’s risk preferences — and, through this, the investment decisions they make — include things like dramatic economic events (like the 2008 financial crisis), economic conditions (a slow or robust recovery, or personal economic well being), and other environmental factors.
Getting to the heart of the paper, one of those factors could be access to and participation in casino gambling. ”We empirically test whether increased risk taking in one context can in influence risk taking in financial investments,” writes Liao. “That is, we study changes in financial risk taking as a direct result of increased risk-taking behavior outside of investment decisions.”
The paper evaluates whether or not investors who began gambling — as the result of a casino opening up near by — developed an increased appetite for risk. Does risk taking beget risk taking? The short answer: yes. ”As hypothesized, we find that those who are more likely to gamble take on more risk in their portfolios after the opening of a casino nearby relative to those who are unlikely to visit the casino,” writes Liao. “Robustness checks confirm that the casino opening is indeed the driving force of the effect.”
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