Synopsis: A man, his nephew and their descendants demonstrate how our perceptions of risk vary over time. And that can be dangerous.
“Gaius…where are you boy?” The Admiral called through the house and heard only his own echo in return.
“By the gods…Gaius Plinius Caecilius Secundus! Answer me!” The old seafarer was in a hurry and his nephew was nowhere to be found.
“Pliny! Now!” He bellowed in his best seagoing voice as he stomped into the courtyard and found the youngster popping figs into his mouth while he stretched out in the sunshine like a cat. His angular knee supported a scroll he was devouring as intently as his snack.
“Yes Uncle?” The boy answered sheepishly.
Breathlessly, the uncle continued: “Come on, we are going.”
“There. Toward that great cloud forming across the bay. It looks like something has happened around Mt. Vesuvius.” Sure enough, a great anvil shaped cloud had blotted out the sky over Herculaneum and Pompeii.
“Gosh, uncle, sounds great and all, but I’ve got a few things to catch up on, and I probably shouldn’t leave mother alone.” The seventeen-year-old demurred, opting to stay behind and read. At least, that was what he recalled later. One suspects he thought better of charging into strange clouds on otherwise sunny days. Well, teenagers know everything, just ask them. Pliny the Elder would never return, perishing with about 12,000 others in the eruption of Mt. Vesuvius in August of 79 AD. His asphyxiated body was discovered under the ash when the cloud finally dispersed a few days later.
Risk is always present. We merely perceive more or less of it and act accordingly. Today, the area wiped out by the eruption is again wealthy and popular. Over 700,000 people now live in the “death zone” around Mt. Vesuvius. Clearly the painful lessons of history are no match for the allure of wine, olives, and ocean-front property. But it isn’t just Italian real estate buyers whose risk tolerance seems to blow with the wind. Our opinions on risk are constantly altered by our environments and our behavior changes, often based on faulty or incomplete perceptions.
Want proof? In a 1999 study, Risk Aversion or Myopia? Choices in Repeated Gambles and Retirement Investments, Richard Thaler and Shlomo Benartzi found that investors in retirement accounts constantly altered their investing behavior depending on their perception of risk. Investors who looked at short term, more volatile returns chose lower proportions of stock for their portfolios than those who looked at longer term returns where losses were less common. With a higher perceived risk, investors changed their behavior and allocated just 40% to stocks. But when shown 30-year returns, with less volatility, perceived risk was lower, and they allocated up to 90% to stocks. Thaler later won the Nobel Prize in economics. He was probably a know it all teenager too.
As investors we need to base the proportion of risky assets we chose to own on factors such as personal time horizon and future needs, not merely a level of perceived current risk. We need to plan ahead. We need to accept the potential for short term loss in order to earn long term gains. We need to make sure that a faulty perception of risk, one way or the other, doesn’t send our portfolio up in flames. We need to act like adults.
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Don't wait for history to happen...