The psychology behind risk behavior
Despite sophisticated risk management tools, it often boils down to a subjective judgment where attitudes – linked to temper and beliefs – affect decisions. The perceived risk is always biased in some way and there are several dimensions to keep in mind. At the workplace, managers treat risk differently, even if they have exactly the same information. Their personality, acumen, and experience lead to dissimilar decisions. How management handles risk will color the risk culture of the organization. First and second line managers watch and often assume top managers’ risk attitude. Therefore, it’s a company-wide issue.
In the following text, I will illuminate some typical risk behavioral concepts and “traps” that individuals and investors risk getting caught in.
Bounded rationality points to the limitations of the human capacity to perceive and manage information and accurately makeup beliefs. This limitation of human intellectual power, especially under constant time pressure, restrains the ability to solve problems in an adequate manner. For this reason, people tend to fall back to mental crosscuts and unwritten rules. Simplicity takes precedence over thorough research and facts, which leads to overconfidence and audacious decision-making without using real information. Economic choices based on perception, memory, and recollection (i.e our knowledge) may be faulty from the outset and before any interpretation takes place at all. Applying risk management processes and strictly using checklists can minimize the consequences.
Expected value theory states that people would choose the investment option with the highest expected value. However, for choice under risk, one can't count on this behavior. Faced by risky outcomes, risk-averse decision-makers may instead prefer sure options, despite lower expected value. People want to be certain that losses are avoided and gains realized – a 100% probability is still worse than complete certainty! This certainty effect means that risk-averse people evaluate absolute certainty disproportionately higher than uncertainty, while risk-prone people would still choose the riskier gamble. Furthermore, the risk is generally perceived as low when the perceived utility is high and vice versa.
Linked to the value theory is loss aversion, where people weight losses heavier than gains of the same monetary value. It’s suggested that people feel losses 2-2,5 times stronger than gains. The phenomenon also depends on the amount of money put into an investment in proportion to total assets. With this follows, an investor who suffers from a not yet realized loss, tends to hang on to the loss as long as possible rather than accepting the inevitable. Instead, he will sell off a possible certain gain too early to compensate for the experienced “dissonance”. This behavior is called the disposition effect. The recommendation would be the opposite, i.e, to take the loss before it gets even bigger and stays with the profitable investment.
Mental Accounting is a behavior used by individuals to organize, evaluate and keep track of financial activities. The basic principle is that payments, connected with a decision, are booked into different mental accounts (not to compare with budgeting and financial accounts). For example, if one happens to win money in a lottery, it’s compelling to regard these as “allowed” to spend not being worth as much as other hard-earned money. The warning flag should be raised when one starts to think in terms of “superior accounts” for good money and “inferior accounts” put aside for bad trades and not taking in the whole picture.
Last but not least, there is the concept of reference point. People always relate a gain or a loss to a predefined reference point, which can be an amount of money, a margin percentage or any other defined point. The level of risk changes when an investor suddenly alters the reference point, to serve his personal well-being.
Coping with risks is far from a trivial pursuit. Beside analytical skills, experience, helpful tools and advanced risk instruments, successful risk management calls for a great deal of self-awareness of one’s traits – weaknesses and strengths. At the end of the day, the latter can make all the difference for the better or for the worse.
To be continued.