According to a landmark study on prospect theory and risk aversion in investing, people are more likely to be concerned about avoiding loss than they are about the possibility of gains. When it comes to successful investing, we can see how that stance might be counterintuitive.
Think of risk as a scale. Our attitudes and behaviors create unique layers that often reside somewhere between risk seekers on one end, and risk avoiders on the other. (For more, see: How to Avoid Emotional Investing.)
Four Risk Approaches
Investors generally fall into one of four distinct risk approaches:
- Avoiders: These investors look for guarantees of return on investment and will often settle for less return to avoid a loss. This group doesn’t generally expend much energy on research and is usually behind their counterparts in retirement savings.
- Mitigators: These investors are more likely to take risks because they thoroughly investigate them. Though they generally have diversified portfolios, they tend to get overly nervous about market fluctuations.
- Managers: These investors are inclined toward a high level of confidence and view themselves as quite savvy. As a consequence, they run the risk of letting that confidence slip from their control.
- Seekers: With these investors, thrill seeking and excitement are catalysts for taking chances. This group does not spend much time researching nor are they usually well diversified. They tend to make snap investment decisions without fully considering the consequences.
Though some people may exhibit multiple approaches depending upon the investment, they usually lean toward one approach as their fallback.
Psychology Behind Risk
Like peeling an onion, there exists a myriad of layers that can help define the psychology behind risk taking and risk aversion. These layers can include perceptions, intuition, personality and emotions. All of these characteristics can have an effect on our level of risk taking.
Perceptions - the nuts and bolts of prospect theory show several interesting outcomes:
- Framing: One might think that given the same options, but presented in different orders, that it might yield the same choice each time. But the variance in how a problem is presented can affect how choices are made.
- Source Dependence: People tend to lean toward choosing options that fall within their area of competence.
- Risk Seeking: People prefer to select a sure loss over the possibility of a larger loss. Conversely, they prefer to select a small probability of a large gain over a measured gain.
- Intuition: There is something to be said for gut instinct. Listening to that inner-self can help us avoid reacting for the sake of a crisis.
- Personality: Those who are outgoing and gregarious tend to take more risks than those who are reserved and anxious.
- Emotions: Though it seems counterintuitive, even fear or excitement can push people into risk taking. (For more, see: Behavioral Bias: Cognitive Versus Emotional Bias in Investing.)
Hone Your Investing Skills
It’s hard not to see ourselves as having sound decision-making skills, but our level of risk taking can be directly related to that skill set. Honing these skills can help investors make better choices. According to the University of Massachusetts Dartmouth, there are seven steps that can be applied to help you with decision-making:
- Identify the decision: Are you certain your focus is the right one?
- Gather facts and information: Do diligent research on what you plan to invest in.
- Identify alternative solutions: Think about other paths to achieve your objective. There is more than one way to attain your goals.
- Weigh all evidence collected: Use some form of analytics (see below) to help you.
- Choose among the alternatives: Select from the alternatives you researched and weighed.
- Take direct action: Implement the alternative you selected.
- Review the decision and consequences: If the result is not what you hoped for, review the steps again.
Weighing the Evidence
When faced with complex problems, there are many coping mechanisms we use like making computational shortcuts and editing repetitive or nonessential aspects. Here are several options for helping investors weigh all evidence:
- SWOT: This is a standard business go-to model that can help you identify and visualize strengths weaknesses, opportunities and threats attached to any decision.
- T-Chart: This chart is the simple, time-tested diagram where we weigh the pros on one side and cons on the other and then compare them.
- Decision Matrix: This matrix is a graph that allows us to rank each factor with a number that can be added up to reveal which option is greater.
- Cost Benefit: This analysis allows us to weigh the financial implications of each alternative outcome to see which makes the most economic sense.
- Pareto: This analysis is similar to the decision matrix, except each possible outcome is prioritized to help one determine the order that offers the greatest benefit.
- Brainstorm: When all else fails, gather your friends and family and toss around ideas. As they say, three heads are often better than one.
Balancing Investment Fears
When it comes to risk, perhaps the best option for most people is to think of it in terms of balance. As investors, we should strive not to control fear, which can overinflate the possibility of failure. So too, we should not underestimate what could go wrong. Both tendencies have a limiting effect and can immobilize us in making decisions.
A certain amount of willingness is necessary for decision-making and risk taking. It is important to be aware of how much risk you are willing to take when investing and be prepared to assess whether you are viewing your risks appropriately. Be aware of your own approach to investing and consider whether your psychological behavior is impacting your investments. Once you are able to properly assess risk in your investments, you will be a stronger investor and make wiser use of your money. (For more from this author, see: 6 Cognitive Biases That Can Derail Your Portfolio.)
Disclaimer: Kris Maksimovich is a financial advisor located at Global Wealth Advisors 18170 Dallas Parkway, Suite 103, Dallas, TX 75287. He offers securities and advisory services as an Investment Adviser Representative of Commonwealth Financial Network®, Member FINRA/SIPC, a Registered Investment Adviser. He can be reached at (972) 931-3818 or at firstname.lastname@example.org.