Dysfunction II: Inappropriate Risk Reactions

In last quarter’s newsletter, we began a discussion on Wisconsin advisor Bert Whitehead’s financial dysfunctions. As you may remember, we looked at seven of them. They were:

  1. Mortgage Aversion.
  2. Inappropriate Risk Reaction: Either fearful or fearless about investments.
  3. Compulsive Spending/Excessive Debt.
  4. Poverty Mentality: Inability to spend money.
  5. Miser Mentality/Obsessive Saver.
  6. Acute Financial Paranoia: Usually accompanied by an all-cash or all-gold portfolio.
  7. Windfall Woes: Usually as a result of lottery winnings, inheritance, divorce settlement, hot stock or other gambling gain.

In the last issue, we examined Mortgage Aversion. In this issue, let’s look at what Mr. Whitehead calls Inappropriate Risk Reaction.

This dysfunction can take two opposite forms. The first is the inability to take any risk at all. Really, this is just a fear of the unknown. It may also be associated with childhood axioms, such as “God punishes greedy people.” As this person’s financial advisor, we might suggest holding common stocks in large well-known companies, such as Pfizer, General Electric or BG&E. When our clients say that they are afraid of the stock market, we can sometimes counter their fear by explaining investment and market risk management and both the time horizon and investment objective of their funds. We have found that if people really understand the risk, they are often less fearful.

The opposite form of this dysfunction is fearlessness in circumstances that warrant some fear. One extreme example may be actual gambling that only “looks like” investing, such as day trading. But what about the people who have a huge exposure to loss in their present investment and ignore it? For instance, they may agree to lend money to a friend to buy a fad food franchise. In this case, the risks are enormous: the odds are that fad food popularity will decline because of competition in retail stores and – well, fads by their nature just tend to disappear. Baskin Robbins, the ice cream franchise, for example, was able to compete with Tastee Freeze but not with Ben and Jerry’s, so they lost their market share not to a retail outlet but to Safeway’s frozen food department. Look at the number of ice cream flavors in your store’s freezer section and remember how few were there in Baskin Robbins’ heyday. Sincere desire to help a friend or relative can override sensible risk aversion and adversely affect those who really don’t have the money to risk. As your advisors we can help you assess risk and avoid this dysfunction.

Another example of inappropriate risk reaction is the recent mania for Internet stocks. A dinnertime call from a broker is really quite irresistible, especially when you have just logged on, excited by all that is happening on the Internet. Your excitement is real, the Internet is real, but the stocks are volatile and usually wildly overpriced. We have had just this conversation with many of our clients in the last two years.

Look for more on financial dysfunctions in future issues. What is your favorite? Do you have friends or relatives suffering from them? Send them to us. We can help.