The Psychology of Risk

The Psychology of Risk

Financial Sector

What do you know outside of your conscious awareness? When it comes to making financial decisions do you know why you do what you do? The field of psychology has researched and tested many facets of the human mind and behaviour that drive the decisions we make. Within the hidden parts of the human mind there are numerous cognitive, emotional, and behavioural biases that activate in the face of risk. Here are a few psychological biases an investor would be good to keep in mind when it comes to financial decisions where risk is involved.

Psychological bias

“A bias is a tendency, inclination, or prejudice toward or against something or someone. Biases are often based on both positive and negative stereotypes, rather than actual knowledge of an individual or circumstance. These cognitive shortcuts can result in prejudgments that lead to rash decisions or discriminatory practices.  – Psychology Today

Psychological bias is a tendency to make decisions or take action in an illogical way; an irrational judgment that leads to poor choices. Without full access to the information about the processes involved in decision making these biases effect investors just the same as all others, whether they are aware of it or not.

Financial choices entail more than rational numbers.  Emotions, biases, past information and experiences combine with the rational to form snap shot judgements. We humans use instincts for survival that affect us today in the same as they did in the past. We run from what might hurt us or we take it on.

In the financial world, as investments may always hurt us by the loss we may face, our minds use both our instinctive survival ‘flight or fight’ response and our ability to calculate hard numbers to come to a financial decision. This is where psychological biases come in. We use a form of quick stereotyping with information that may not be true to come to decisions in-order to prevent damage from loss.

Behavioral Finance

The relatively new field of behavioral finance does research to “identify and understand human behaviour and decision making with regard to choices involving trade-offs” – the risk and return of the financial sector. What is being discovered is that the same biases that used to make decisions in the daily life also effect financial decision making. That means that when you make choices you think are based only on number calculations it is not the case. Your mind also adjusts your perspective and uses the information from you experiences to come to a decision, which can lead to judgements that are not as advantageous as they should be.

Loss Aversion

‘Loss aversion’ is the tendency to place more weight on the feeling of loss rather than gain. This creates the aversion which means there is a need to get away from the loss. It is like an allergic reaction. The instinct to run from loss can lead to riskier gambles. It has been found in studies that individuals who are losing when gambling, for example, will make risker bets – in hopes of recovering what they have lost.

People would assume the individuals would take less risk to be safer. Without focusing on the fact that you may lose that much more, the bias towards loss (loss aversion) makes the mind decide to take more risk based on emotion. Higher returns can only come from higher risk, not safer risk.  To explain further, if in a bet of 10-1, you bet $1 you may win $10 or lose one dollar. If you bet $10 dollars, you may win $100 or lose $10, and if you take the risk of betting $100 you could win $1000.

Framing

Framing effect –is the tendency of the brain to arrive at different conclusions when reviewing the same information depending upon how the information is presented.

Framing is a bias that adjusts how a person perceives and reacts to a problem or situation depending on how it is presented, whether positive or negative.

When framed in a positive light people see more in terms of opportunity and positivity. They are less worried about having to make up for loss and are less inclined to take risk.

A negative frame, as seen above with ‘Loss aversion’, can induce risk taking. If the situation seems dark, you may felt anxious, worried, panicking, put in a negative view, and so feel the need to put all you have with hope of gaining more.  

Let’s say for examples sake you are presented with the statement ‘you succeed 50% of the time’, a positive frame, verses ‘you lose 50% of the time’. How do you feel with each? Each sets a certain tone that effects conscious decision making, without our knowing, though both refer to the same situation.

Overconfidence

When it comes to overconfident investors “mistakes” get made. It can produce an overestimation of the probability of success because they are overly confident about their investments. Let’s say you hit a few consecutive winners, you could start to believe that there is less risk to each venture than is true.  This is an underestimation of risk involved. There will always be risk, it doesn’t go away because you have been successful. There will always be random factors, events, situations that give uncertainty its tune. For example, the real estate market may be up and provide success. But a natural disaster may hit, a political situation may spark, the value of the dollar may drop, or economic recession may strike. Then what happens to your major investment in the real estate market?

Familiarity Bias

This bias is about staying with what is familiar to you, and always sticking to it. This can lead to an under-diversification of investments and in turn a big loss. When under-diversification occurs, management of the investment portfolio is restricted to the same sectors or related, asset classes, geographical location or stock.

An example would be investment into one company’s stock that you are familiar with or in only one country. If you stick to familiar investments if any risk hits that industry you could loss all.

If based on minimizing the amount of risk alone however, the opposite strategy of diversification across different sectors, asset classes and geographical location would save you from an amount of uncertainty. For examples, if company X in the transportation industry in the German, company Y in the publishing industry in the U.K, and company X in the hospitality industry in Qatar were invested in, the overall return would be better off if something interrupts one of the industries or one of the countries situations – it reduces the risks.

Representative Bias

This bias is the tendency to take a sample and use it as representative of the whole. It could be taking one aspect of a company and apply it as a judgement about the whole business.  For example, you might think a company that sells high quality products is a good investment. This would be a misattribute of a positive characteristic to the whole. The quality of product does not necessarily represent the financial situation of the company though, which may be going bankrupt – irrelevant of how well made its products.  

Anchoring Bias.

Anchoring effect is the tendency for the brain to rely too much on the first instance of information it received when making decisions later on.

Anchoring is the tendency to use previous information, or specific information, when making a decision. To anchor is to use a bench mark of past information as a standard to expect and interferes by allowing for an unrealistic or illogical expectation. For example, a sell-price becomes based on what you think “should” be as opposed to what the fair price of today is and means you may miss out on the opportunity to buy or sell. 

The balance between risk and return and the financial decisions we make have more depth than a simple rational calculation. We are not computers; we are affected in ways unknown to us especially when risk is involved. Understand and watch for your own cognitive and emotional biases. Self-awareness, growth of knowledge, and the generally questioning of whether you use all the information available can improve the decisions you make in the financial sector. Awareness of these unconscious process of decision making can help us make more optimal and advantageous choices for successful investing.