The Psychology of Investment Risk

What is risk? How is it defined? Wikipedia defines it as “The possibility of something bad happening”. With such a negative connotation to risk, why does is still entice people to pursue it? Everyone seems to have a different perception of risk. It is this variation in perception that makes risk seem forbidden and yet attractive.

Risk plays a critical role when it comes to investment management. In the investment world, the amount of risk that someone is likely to take is highly associated with the individual’s capacity and willingness to withstand the impact of market volatility on their investment portfolio. More specifically, capacity is the financial ability to absorb losses without jeopardizing financial security and willingness is the psychological comfort one has with risk. Both capacity and willingness to take on investment risk is highly associated with various psychological factors.

Herd mentality and a fear of missing out can influence people to make investment decisions based on what other people are doing. Herd mentality can lead to a perceived increase in capacity. Without an understanding of our own risk tolerance, following the “herd” may not always be beneficial for everyone. In contrast, risk aversion can also lead to missed opportunities. Risk aversion can reduce the willingness to invest in volatile assets. When the pain of loss is assumed to be greater then the pleasure from an equivalent gain, it can feel less beneficial to invest in assets perceived to be risky, even though the returns look to be lucrative.

Emotional biases such as fear can lead investors to sell in a market downturn due to the perceived sense of loss and desire to avoid further loss. In contrast, greed can lead investors to make purchases for quick profits, without regard to the long term impact of the purchase. Certain cognitive biases can also significantly contribute to the decision making process. For example, anchoring and/or confirmation biases also lead people to make buy/sell decisions either based on past performance (anchoring) or through information that confirms with their existing beliefs (confirmation).

The best way to mitigate against the impact of our biases is to become self aware of them. Utilizing a risk tolerance questionnaire can give us a better understanding of our capacity and willingness to take on investment risk. It incorporates questions that forces us to think about our biases through different investment scenarios. It is not to say that our biases will lead to the wrong decision, but for prudent investment decisions, it is critical to understand risk tolerance based on all pertinent information, including our biases.