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March 17, 2018

Risk Tolerance, Age and Market Direction

An investor’s willingness to invest in stocks varies with the level of the S&P 500 index and other major indexes. Similarly, in aggregate, older investors tend to be more conservative than younger investors. Neither statement should be a surprise to those of you who have been investing for a long time and/or are familiar with market cycle trends in the investment industry.

A recently published study in the Journal of Behavioral Finance looked at the link between age, risk tolerance and the S&P 500. It sought to determine whether older investors exhibited greater risk aversion when the index declined in value than younger investors did. In other words, the study’s authors weren’t trying to confirm whether older investors are less inclined to risk capital in hopes of future gain during declining markets, but whether their risk aversion increases more than comparatively younger investors.

Risk aversion was assessed through a questionnaire given to participants of defined-contribution plans [e.g. 401(k) plans] offered through Morningstar Associates. (More on using questionnaires to assess risk in a moment.) Approximately 29,000 investors were surveyed. The correlation between average monthly risk aversion and the S&P 500 was –0.46 for the 51- to 65-year-old age group versus –0.20 for the 20- to 35-year-old age group. The negative numbers show that investors’ aversion to incurring a loss declined as the S&P 500 went up and increased as the large-cap index declined. The larger negative correlation for older investors indicates a stronger inverse relationship between risk aversion and the stock market’s performance.

The relationship is not perfect. A correlation of –1.00 would indicate a direct negative relationship. For example, for every 1% decline in the S&P 500, an investor’s risk aversion would increase by 1% and vice versa. The fact that the correlation for the younger investors is closer to zero shows that those in this group are less sensitive to swings in value of the S&P 500 than those in the older group. This makes sense because older investors are more likely to rely on their portfolios to cover living expenses, lack salaried income and have shorter investing time horizons. Young investors, conversely, may not need to withdraw from their portfolio for three or more decades.

The level of aversion among both young and old investors did change with the market conditions. During the last bear market, the correlations between risk aversion and the S&P 500 were –0.296 and –0.696 for the young and old investor groups, respectively. Notice how both turned more negative, indicating greater risk aversion as the stock prices fell. During the subsequent market rebound (2009 through 2012), the correlations turned slightly positive at 0.158 and 0.022, respectively. Younger investors began to show slightly more caution when stock prices rose, while risk aversion among older investors essentially became uncorrelated with how the S&P 500 performed.

The changing nature of risk aversion should give you pause if you’ve ever used a risk questionnaire to determine your suggested allocation. Questions about your willingness/ability to incur market-driven losses will elicit different answers depending on the current state of the market. You may feel far more confident about your ability to withstand a loss when stocks are doing well and volatility is low than when the S&P 500 is falling and volatility is high. Good market conditions may cause your perceived ability to tolerate risk to be higher than it actually is, while bad market conditions may lead you to adopt a more conservative allocation than you are actually able to tolerate.

The Week Ahead

Saturday is St. Patrick’s Day; wear something green.

Just as fourth-quarter earnings season has ended, we’ll start to get a look at first-quarter results. Dow Jones industrial average component Nike Inc. (NKE), which will report on Thursday, will be joined by 10 other members of the S&P 500. Included in this group are Oracle Corp. (ORCL) on Monday; FedEx Corp. (FDX) on Tuesday; and Accenture PLC (ACN) and Micron Technology Inc. (MU) on Thursday.

The Federal Open Market Committee will hold a two-day meeting starting on Tuesday. A quarter-point rate hike is widely expected to be announced when the meeting statement is released on Wednesday at approximately 2 p.m. Eastern Time. Updated committee member forecasts will be released at the same time. Jerome (“Jay”) Powell will hold his first press conference as Federal Reserve chair at 2:30 p.m.

Elsewhere on the economic calendar, February existing home sales will be released on Wednesday. Thursday will feature the March flash composite Purchasing Managers’ Index (PMI). February durable goods orders and February new home sales will be released on Friday.

Two Federal Reserve officials will make public appearances: Atlanta president Raphael Bostic on Monday and Friday, and Minneapolis president Neel Kashkari on Friday.

The Treasury Department will auction $11 billion of 10-year inflation-indexed securities (TIPS) on Thursday.

Courtesy of Charles Rotblut, CFA is the VP and Editor for American Association of Individual Investors (AAII). Charles is also the author of Better Good than Lucky. (EconMatters author archive here)  

The views and opinions expressed herein are the author's own, and do not necessarily reflect those of EconMatters.

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