How do you think about risk? The psychology behind investment decisions

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By Mike Abbott

Deciding on the risk you take with your investments is a slippery subject. One is more likely to think rationally about the concept when your own money isn’t involved. Below we run through some common psychological factors that can influence investment decisions. Understanding these can help you make a clear decision when navigating volatile financial markets.

  1. System 1 hijack

Do you ever feel scared of sharks when you’re swimming in the ocean? Or a twinge of fear when flying in airplanes? If you answered yes to either of these, your “System 1” brain has hijacked you.

Nobel Prize winning psychologist and economist Daniel Kahneman put forward a theory of two systems we use to make decisions. System 1 is instinctive, fast and primed for survival. This system has much to do with humans being the apex predator on planet earth. It has served us well, but it’s not very good at processing statistics. It can’t process the fact that you’ve placed a very high level of threat onto an event that statistically has a close to zero probability (i.e. sharks and plane crashes).

System 1 is a gut instinct that overrides your head. It’s the reason we say financial volatility is driven by fear and greed. If system 1 gets involved in your financial decisions, there’s bound to be trouble.

  1. Anchoring

If you were asked what return you want to achieve with your pension fund per annum over the next 25 years what would you answer? Respondents to this question usually give a very wide range of answers. But if you knew that between 1700 and 2010 the return on equities was 7% per annum, on property 5% and on bonds 4%, would that change your answer?

Your responses have now been framed as you have some historical markers to calibrate your expectations. That advert promising you 25% annual returns from a new stock market trading strategy will now be seen for what it is.

  1. Loss aversion

If you’re offered a seat in a coin toss game where you put R10,000 in and you could win R10,000, would you play? There’s a 50% chance of losing or winning R10,000, which are good odds, yet the real world very few people are willing to take this bet. This is because we all suffer from of loss aversion. That means we feel more aversion to a 50% loss than we feel good about a 50% gain.

You need to offer a gain of double the potential loss to get people to play this game.

The stock market also offers the chance of gains and losses. . The longer one invests in the stock market the lower the probability of loss. Data on bull and bear markets shows the asymmetrical upside of stock markets. Bull markets are, on average, 7.5 years long with a total upside return of around 390% while bear markets are, on average, 1.5 years long with a typical downside of 39%. Is that a game you would be willing to play?

  1. Availability bias

Why do professional property investors also want to invest their private savings in property (usually in regions close to home)? It’s for the same reason private equity professionals prefer investing in private equity funds and stock market traders like running personal stock portfolios.

We are influenced by what’s most readily available to us. The most appropriate asset class may be singular or a combination, but how comfortable you are with the asset class is determined through familiarity with that asset class.

Another well documented feature of the global investment landscape is home bias. Investors from the UK tend to overweight in UK assets. All countries display varying elements of home bias even when it’s not appropriate, such as in countries with high levels of political risk (like South Africa at the moment!).

  1. Sunk cost fallacy

Imagine you own a significant investment portfolio in a risky market like South Africa but you live in the United States. Your South African portfolio has taken some losses (say -25%). If you left South Africa due to the concerns about the political future then the loss is now a sunk cost. If you retain this investment hoping it will bounce back, you risk doubling up your loss. The odds of that investment improving have not changed now that you have taken a loss.

This is no different than the gambler who calculates his odds of winning the next hand differently because he just lost R10,000 in the previous hand. The lost R10,000 is now a sunk cost and the odds of winning the next hand are the same.

Can you afford to take the risk?

As professional investors, we’re forced to grapple with slippery concepts like risk profile and capacity for loss. These two concepts are different in very important ways.

Risk profile is your psychological willingness to take a specific amount of risk. Your perception of those risks is further filtered through and influenced by various biases and psychological traps as discussed above. Your risk profile is influenced only by your willingness to take risk and has nothing to do with your actual capacity for loss.

Capacity for loss is about your financial situation as it compares to your lifestyle costs and goals. Do you have the finances to absorb your loss?

An example

A 90-year-old millionaire with no heirs may have a very low risk appetite – preferring to keep all her money in government bonds. However, her modest living costs would suggest she has a significant capacity for loss.

Conversely, a 23-year-old CFA student in his first job as a bond analyst might have a considerable appetite for risk. However, the £10,000 he has in his ISA is somewhat overshadowed by his considerable student debt. He has a high-risk appetite but a very low capacity for loss.

Navigating your financial health

Staying aware of potential psychological traps and reconciling your personal attitude to risk with your capacity for loss can be a tricky task.

As financial advisors it’s our role to advise clients through the various life phases where risk appetites and the capacity for loss can sometimes be moving in opposite directions. Investment risks need to be considered within the frame of liquidity needs, accumulation rates and debt levels. No matter how interesting a risky investment idea might be, it should always be related to your own situation. A professional can take an unbiased approach to help you do that.

We offer unbiased, whole-of-market, cross-border financial advice that always takes your unique situation into account. For personalised, cross-border investment solutions, email [email protected] or call +44 (0) 20 7759 7519.

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