Time to check your risk appetite

It’s been a great year 2021 for investors. Stock markets in the United States, the UK, and Europe were up more than 20% in 2021, private equity was up more than 70% (at least in the listed space) and real estate was up more than 20% globally as well. As long as you didn’t invest in emerging market equities, gold, or nominal government bonds, all of which had negative returns in 2021, it was very hard not to make money last year.

This is why I want to warn you that a year like 2021 is a dangerous blessing. Behavioural finance research of the last forty years has taught us that investors, no matter how sophisticated they are, see their risk preferences drift in reaction to past experiences.

The disposition effect tells us that investors are more likely to sell stocks that are held with a gain, foregoing future gains, and are more likely to hold on to stocks that are held with a loss. So, what is the problem here? After a great year like 2021, shouldn’t you sell some of your winners and take profits? Yes, but the disposition effect works with paper gains and losses, not with realised gains or losses.

There is a weird effect that if people sit on paper losses, they are reluctant to sell those stocks in the hope of selling them later with fewer losses or at a gain. But if investors have realised their losses in the past, they are more reluctant to invest in the same stock again or invest in risky assets in general. If you have been bitten once, you are thinking twice about going near risky investments again.

Similarly, investors who are sitting on paper gains are more likely to sell some of their investments to lock in their gains while investors who have realised gains and sold in the past are becoming more optimistic about their abilities as investors and more risk-seeking in their investments. They are starting to feel invincible, which is why they suddenly start to double down on investments that have made them money in the past.

So here is the challenge for you. If you are an investor and you are sitting on paper gains, by all means, rebalance your portfolio and trim some of the holdings that have rallied strongly. But remember that if you trim these holdings, you are tempted by your own brain and the warm fuzzy feeling you get from thinking about past investment success to double down on investments that have made you money in the past. At the moment, these are likely to be energy and commodity stocks while you will probably be more reluctant to invest in retail stocks which have done poorly in 2021. But 2022 is not going to be 21 again, so resist the urge to invest in the stocks that have made you money in the past.

Also, resist the urge to trim gains in some risky assets just to invest them in other risky assets. Rebalancing means reducing risks to a more normal level and not letting them go out of hand. This may mean that you have to buy government bonds even though you feel like they are not going to make you any money in 2022. I don’t like government bonds either, but they are still an important safe asset in a portfolio that can protect your investments against negative surprises. And who knows what 2022 will throw at you.