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How we manage our money can often differ significantly from how traditional finance prescribes. The reality is that most of us struggle to conform to the requirements to act as rational economic men.
Traditional finance assumes that individuals are risk-averse, have perfect information, and focus on maximising their personal utility. Behavioural finance will analyse how individuals behave and make financial decisions.
Risk is a central concept to investing, and how we handle risk is a major determinant of our approach to investing. Investors’ risk tolerance can range from risk-averse, to risk-neutral, to risk-seeking.
Let me illustrate by way of an example from FinaMetrica:
Explanation: As this investment would pay back on average
R15 000, a risk-averse investor would place more importance on a potential loss
than the potential gain in investment. Accordingly then, the investor would pay
less than the expected payoff of R15 000. However, a risk-seeking investor
places more importance on the potential rise in the investment than the
potential loss, hence they would be willing to pay more than the R15 000.
Understanding your risk profile as an investor is a central step in determining your optimal level of investment risk, and then what type of investment is best suited to you based on this. There are three components to consider:
Risk required: The risk associated with the return required to achieve your goals from the financial resources available;
Risk capacity: The level of financial risk you can afford to take; and
Risk tolerance: The level of risk you are comfortable with.
Our risk tolerance will dictate our comfort with various levels of risk. Naturally a low risk tolerance will produce risk-averse behaviour in an investor. Humans naturally find loss painful. As a result, the pain of a loss (or a potential loss) can prevent us from taking on a calculated risk, even when the rewards are potentially significant.
Generally, we as investors hate losing money much more than we enjoy winning. Compare how happy you would be with a 10% return on your portfolio versus a 10% loss? However, the behaviour of averting loss can lead to averting gains, an often unintended and punitive consequence.
Let’s look at an example to illustrate:
By trying to
avoid loss and investing in lower risk investments, the “cost” of this safety
is often under-appreciated. If an investor had R100 to invest for five years,
using historic data, the amount would have grown by the following:
By attempting to avoid losses and moving into safer investments, investors run the risk of paying for this safety with negative real returns (returns after inflation).
However, investors do not always handle risk in a uniform manner. Empirical studies have shown that most investors are risk-averse when presented with gains, and risk seekers when confronted with likely losses. Many people simultaneously purchase low-payoff, low-risk insurance policies (risk-averse behaviour), and low-probability, high-payoff lottery tickets (risk-seeking behaviour).
Let me illustrate by way of two examples:
Would you invest in an opportunity that has two equally possible outcomes:
Make R10 000 or lose R7 000. Although the expected payoff is actually R1 500 profit, the majority of investors would not take the opportunity. [Both outcomes has an equal probability of occuring (+R10 000 or -R7 000). The average expected return will therefore be (R10 000-R7 000)/2 = R1 500.]
As another example, an investor was offered a choice of a guaranteed loss of R600, or a 50/50 chance of making R600 or losing
R2 000. Investors exhibit risk-seeking behaviour here and go for the 50/50, which is a payoff of R700 and worse than the sure loss of R600.
We also see evidence of this innate risk aversion in the way investors handle profitable as well as losing investments. Investors have an aversion to realisation of losses (selling assets that are below their purchase price). In what is termed the Disposition Effect, investors tend to sell shares whose price has increased early, and keeping investments whose value has dropped.
The tendency for investors to realise gains but their reluctance to realise losses is considered irrational behaviour, as decisions to sell and hold should depend on the perceived future value of a security, not the purchase price.
It is evident that most investors are not rational economic men. Our psychology, brain chemistry and emotions all contribute to our decision-making, creating biases that can cause our decision-making to become irrational. However, awareness of these biases will help to resist or overcome them. Now where’s that lottery ticket?
Devin Shutteis the head of investments at The Robert Group, a private wealth management company.
This article originally appeared in the 6 April edition of finweek. Buy and download the magazine here.
