Human behaviour is not always rational. After all….we are human! Much of our behaviour when it comes to managing money is driven by emotion more than logic, leading us to make decisions that, while they might not be optimal in the objective sense, at least make us feel better or safer. And that is OK. There is no point making decisions about money that leave us lying awake at night, scared or worried.
This is particularly true with making investments. Some people are comfortable taking a lot of risk, others aren’t. Some people panic when their investments fall in value and some don’t. There are a number of reasons why people have different feelings about risk.
First of all, what do we mean by risk? The definition of investment risk is not the probability of losing money, but the probability that the investment outcome will not be what you expect. Risk therefore includes volatility as well as loss.
In essence, there are two aspects to how much risk you are willing to take. From an objective point of view, there is the question of your capacity to take risk. By that I mean any financial decision needs to consider your overall financial situation. Clearly, if you have limited financial resources, you do not have the capacity to take big risks. On the other hand, if you are well-off, you are in a better position to handle any losses that might arise from risky investments.
But then there is the second aspect, which is the emotional one. Even well-off people may be reluctant to take risks because by nature they are risk averse. What is it that causes people to be risk averse? There is a combination of psychological factors at play.
Some of our attitudes towards risk are embedded early in childhood by parents who were risk averse. In times gone by, the emphasis was on saving rather than investing. Such sayings as ‘save the pennies and the pounds will take care of themselves’ – and there are lots of others – entrenched the idea that we need to be careful with money.
Another even more important factor is past experiences. Risk averse people will often quote examples of situations where family, friends or acquaintances have lost money, usually through making poor investment decisions, but with the excuse that the losses arose because the investments were too risky. Investment markets are characterised by ‘crises’, which really just means volatility. Volatility does not cause losses – bad investment choices do. Volatility is remedied through diversification and time in the market and those who lose money have usually broken one or both of those investment rules.
A man by the name of Harry Markowitz won the Nobel prize for his research on the relationship between risk and return – people want to minimize future regret of either missing out on gains or suffering losses. What has been found is that investors put more weight on the pain associated with a loss or drop in value, than they do on the good feelings they get from gains. In fact, research on loss aversion shows that investors feel the pain of a loss more than twice as strongly as they feel the enjoyment of making a profit. They are confident investors when the market is rising, but panic when it falls.
This kind of investor behaviour is what drives much of the volatility in the share market. In essence, it is fear and greed that fuel the ups and downs. If we were to take emotion out of the picture, share prices would reflect expected future company earnings. There would still be some volatility as earnings follow the economic cycle. However, this volatility is magnified by the emotional reactions of investors. When things are going well, investors rush with enthusiasm into the market – you only need to look at what has happened in the last two years to see that. The increased demand for shares leads to a rise in price of shares. But when things are not going so well, investors panic and sell. The oversupply of shares for sale leads to a drop in price. When this happens, bargains can be found, as share prices fall below what their objective value is, based on future earnings.
Astute investors understand all these dynamics and take advantage of opportunities.
The best way to overcome risk aversion is to learn more about investing. That’s not to say that the aim is to take on more risk, but to be able to make a good return while still being able to sleep at night.