When will our risk aversion wear off?

Wed Nov 9, 2011 1:45pm EST

A traders works on the floor of the New York Stock Exchange March 25, 2009. REUTERS/Eric Thayer

A traders works on the floor of the New York Stock Exchange March 25, 2009.

Credit: Reuters/Eric Thayer

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(Reuters) - Amid a burst housing bubble, worldwide jitters over government debt and the high-profile recklessness of some financial movers and shakers, markets in the U.S. and abroad have taken a beating.

Risk today, in almost any form, is seen as the enemy by a growing number of investors.

This sort of hyper-aversion fascinates academics such as Victor Ricciardi, an assistant professor of financial management at Goucher College in Baltimore, Maryland. He writes about behavioral finance -- that nexus where people's financial decisions meet their unique psychological profiles.

As Ricciardi explains it, people make financial decisions rationally -- based on mathematical models and hard statistics -- or based on gut feelings, the way poker players do. Trouble is, the turbulent markets of 2011 have largely confounded investors of both kinds.

And no matter how you invest, losing money almost always stings. "When people lose a lot of money, it's an emotional loss," Ricciardi says. "And that emotional loss stays with them for a long, long time."

So when does the risk aversion end? That's like asking a Chicago Cubs fan what it's like to lose year in and year out. "Investors often behave like sports fans," says Hersh Shefrin, a professor of finance at Santa Clara University in California. "When things are going badly, they get the feeling it will never get better."

Add the shocking collapse of MF Global, which filed for bankruptcy protection October 31, and it equals a recipe for long-term investor risk aversion.

After all, if MF Global could once boast in its annual report that "effective risk management is critical to the success of our business," and flame out so spectacularly, then who on Wall Street can be trusted? Or have some investors reached the point where the only risk worth taking is no risk at all?

"It's totally understandable, if it's not logical," says Charles Sizemore, principal of Sizemore Capital Management in Dallas, Texas and author of the Sizemore Investment Letter.

He cites a landmark 1979 study by psychologists Daniel Kahneman and Amos Tversky, who found that people dislike losses 2.5 times more than they like comparable gains.

This may explain why many investors dwell more on the bad times than good -- and why every MF Global brings a boatload of bad memories back to life.

"Generals fight based on the last war, and investors invest from the last market -- and 2008 was devastating, maybe the worst since the Great Depression," Sizemore says. Investors "who rode it out can't bear to go there again. They're timid to do anything."

For some, short-term relief lies in higher cash allocations to portfolios. Advisers usually keep 4 to 6 percent in cash-related liquid investments, says Wayne Cutler, who co-chairs wealth and risk management practices at Novantas LLC in New York City. "But for the past three years, it has hovered between 12 percent all the way up to 20 percent. And we believe if interest rates were higher, the cash investments would be even more."

Cutler paints the anxiety in literal life-and-death terms: "Consumers, especially those in or close to retirement, don't know where to put their money," he says. "And now that their home equity nest egg has for the most part vanished, they are extremely worried about running out of money before they die."

Financial managers chew their nails for a different reason: They could help scores of anxious investors, if only people would use them.

A new study from Indiana University's Kelley School of Business finds that despite the rocky economy, relatively few investors seek professional guidance that could keep them on solid financial footing.

The study offered financial guidance to more than 8,000 active retail investors. The advice was free of charge, generated by an algorithm designed to improve portfolio efficiency -- and absent of bias or monetary conflicts of interest of the brokerage.

The conclusions were alarming: Only 5 percent of investors accepted the free, non-biased advice. "We found ourselves with a modern, financial version of a horse we'd led to water, but we couldn't make it drink," said Utpal Bhattacharya, a Kelley School finance professor and co-author of the study.

So how long will anxious investors sit on the sidelines? All it takes is a short winning streak to spark some hope, observers say.

As Shefrin puts it: "Batting slumps end, and markets do turn around."

That goes for good times as well as bad. Remember when former Federal Reserve Chairman Alan Greenspan coined "irrational exuberance"? 'Twas 1996, and tech stocks were through the roof -- and, simultaneously, perched on a precarious bubble.

Fast forward to 2011, where browbeaten markets could use even a pauper's ration of that exuberance. Emotions still dominate, but of a darker variety.

Call it the age of "irrational anxiety."

---The author is a Reuters contributor. The opinions expressed are his own.

(Editing by Lauren Young, Beth Gladstone and Walden Siew)

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