Issue: 36
Sent: 01-05-2006 21:15:20
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What is Risk 5 - Lester Wills
Continuing my discussion on risk, I am looking further at the behavioural finance view. In other words, subjective risk, what individuals go through when they invest.
Many have met people who invest and talk about how much money they have made through trading their shares. However, it has been found that individuals, who trade too much, are usually reluctant to sell losers.
This is primarily based upon an overconfident belief that they can pick winners. In reality it was found that usually the stocks picked performed worse than those that were sold. Meanwhile even though the purchased "winners" under-performed, there appeared to be an inherent reluctance to sell them.
This is because investment decisions have both an emotional and financial consequences over time. There is significant potential for worry and pride, for elation and regret and the worst one of all, guilt. This can be from having used money earmarked for a special purpose, or from not having taken the opportunity when offered the chance.
A financially optimal decision, namely one that a fully rational investor would make is of little use to an investor who cannot live with the uncertainty. As Kahneman argues, an optimal decision is of little use if it means that the investor is likely to change their mind before the agreed time horizon.
People generally do not like to lose, and especially do not like to lose money. Regret makes any loss even worse. A losing investor who believes that they should have anticipated the poor performance is likely to feel worse than if it could not have been predicted.
Now comes the rub. Those prone to regret are likely to look for someone to blame. Any scapegoat will do and their financial adviser can all too easily fit the bill. To quote Kahneman & Riepe, "the combination of hindsight bias and regret creates a powerful toxin". With the benefit of hindsight, all things that happened are obvious, so why did the advisor fail to give good advice?
For those who wish to know more about the area I include some sites to visit and some references for background information. I must stress that I am not endorsing these sites, merely providing a route to get there, it is up to the individual visiting the sites to make up their own minds as to how applicable they consider the information to be.
A site that is worth a visit is http://www.financialpsychology.com the home of Money Max and Dr. Katherine Gurney, the author of Your Money Personality. In the book she says,
"For most of us, money and our feelings toward it are not static but fluid, dynamic and intense. We love money or we hate it, we fear it, or we worship it, or we enjoy it but we certainly never ignore it. And yet, we know so little about why we experience these emotions toward money and the effects they have on our very existence."
On the issue of risk she talks of risk-avoiders ending up with inappropriate portfolios and effectively buying themselves sleepless nights and nail biting days, no matter how much profit is made.
Another site that may be worth looking at is http://www.moneysolutions.com.au/home.htm. This is the Australian version of material developed by Dr Katherine Gurney.
On the site it explains that; "the Moneymax Profile Report shows the client's scores in relation to 13 financial traits which places the client closest to one of nine Moneymax Groups. Each Moneymax Group has both strengths and weaknesses. Being aware of these can help to develop a successful financial strategy."
Another is http://www.moneyvalues.com.au
On the site it argues, "Much debate has been waged around "risk"-defining what it means and in particular, what it means in investment terms. The statements in this Factor are designed to uncover how people feel personally about financial and money management risks. It measures and discusses who are most inclined toward risk (or aversion) and notes some interesting conditions and provisos."
Another site is http://www.risk-profiling.com which has a plethora of information and articles about the whole subject. In the site they argue "Risk, risk tolerance and risk tolerance testing have been the subject of numerous research studies over the past twenty years and are now well understood in academic circles. But, to date, very little of this understanding has crossed to financial services."
For those who wish to do some reading on the area of Behavioural Finance I would suggest considering the following:
The Psychology of Investing - Lawrence E. Lifson & Richard A. Geist
Behavioral Finance - Joachim Goldberg & Rudiger von Nitzsch
Investment Madness - How psychology affects your investing ... and what to do about it John R. Nofsinger
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