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The psychological effects of risk

When investing, the degree of risk that you assume will most often provide a better return over the long run. This is why a GIC will provide a lower return than investing in stocks. While the stocks are riskier and can certainly leave you with losses, over the long run you might be able to expect 7-10% with a properly allocated portfolio.

So if we understand the positive effects of investing in stocks over other safer investments, then why do we choose to invest in less risky products? While a certain level of risk aversion can be a good thing, would we make the same choices when faced with losing money?

Daniel Kahneman and Amos Tversky developed Prospect Theory in 1979, a study based on decisions that are made when presented with varying amounts of risk. What they found is that 80% of the people questioned would take a guaranteed $3,000 over an 80% chance of gaining $4,000. Now if there had been annual investment returns, the second choice would assume a risk of having a year without any gains. However, if you invested in the long run, your average annual return would be $3,200. Despite the second option providing a larger return, only 20% of those questioned made that choice.

Kahneman and Tversky then looked at the same question related to losses instead of gains. Now an amazing 92% responded that they would rather take the 80% chance of losing $4,000 over the guaranteed loss of $3,000. With the same math again, almost everyone chose an average $3,200 loss over the $3,000.

While you need to invest within your comfort level for risk, this research shows that the majority of us would choose a lesser return in an attempt to avoid risk. What I found interesting though was when our investments are losing money, and it’s unlikely to recover, we choose to increase our risk which leads to greater losses.

The theory seems to hold true in real life as well. Have any readers chosen a Canada Savings Bond over an index fund, to later look back at the gains you missed out on? Or held onto Nortel for too long while hoping your losses would be reduced?

Comments

  1. Jason @ Redeeming Riches

    In my experience, most people really have no idea what their risk tolerance is. They think they’re aggressive when markets are good, conservative when markets are bad and then when they lose money – as you point out – they get more aggressive to make up lost ground!

  2. Craig

    That’s why there is buying remorse and impusle buys. Psychological affects a lot of purchases and the risk / reward scale.

  3. Financial Samurai

    The pain of losing money is worse than the euphoria of making money unfortunately.

  4. John Nemeth

    Or, maybe they are better at math (even if just intuitively). Each role of the die (or, each year of investing in the markets) is completely independent of any other. There is no average! This article proves that you can’t do math.

  5. The Rat

    I’m pretty sure its a safe bet to say that after this past year’s market meltdown, a lot of people hurriedly sold a boat load of mutual funds as prices nose-dived, only to realize the timing was bad.

    Any money sense magazine will have its horror story depicting a family who virtually ‘lost it all’. It’s amazing how many people have been affected psychologically by risk and what the ramifications can be by taking too much on. I think risk is misunderstood and often underestimated.

    Nice post!

    What I find

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