More than simply an absence of certainty; risk is about our inability to deal with probabilities in a consistent and coherent fashion, and the discomfort caused by the fact that “more things can happen than will happen”
Central to our relationship with risk is how we are feeling at any given time. There is even a formal hypothesis for the role of emotion (or affect) in decision making called ‘Risk as Feelings’, in which George Loewenstein and colleagues argue that emotional reactions often dominate behaviour leading to our decisions diverging markedly anything that might be considered objective or rational. How we feel about something tends to have an overwhelming impact on how we view the probabilities and potential outcomes.
Whilst dread risk suggests that we often hugely overstate certain low probability, high impact risks, there are other activities where individuals seem to ignore them entirely – for example, driving under the influence of alcohol. This apparent contradiction is a prime example of the inconsistency of human behaviour.
When it comes to risk, the crucial issues are salience and availability.
If something hasn’t occurred for a long time or hasn’t recently stirred our emotions, we might simply disregard the risk entirely.
Salient, emotive and recent events can overwhelm our perception of risk and the investment decisions we make. It leads us to become complacent during prolonged equity bull markets and fearful in the midst of a bear market. We can think of this as our erratic perception of risk continually shifting our personal discount rates.
Whilst the role of emotion and behavioural bias makes all types of decision making difficult there is an extra problem when we consider our investments. Many important life decisions are discrete and made at a single point in time – whilst we will be subject to the behavioural problems when buying a house, once we have made that decision it is not easy to reverse course – we don’t have to make the same decision over and over again. For investments the opposite is true – once we make an initial investment decision the flexibility to change course means that we are forced to repeatedly face the same choices, but whilst the fundamental decision might be the same – our biases and emotions are likely to frequently alter how we perceive the risk in the decision.
Financial markets also lure us into being excessively diverted by what we might call ‘secondary risks’ or those that are subordinate to our primary objective.... We often make decisions to manage or mitigate these secondary risks, even if they jeopardise achieving our primary objective.
It’s not simply that we are thinking about risk in the wrong way, but we are thinking about the wrong risks entirely.
Risk is about our individual differences, how frequently we check our portfolios, how we are incentivised, the last thing we saw on the news, recent stock market performance and how readily we can recall similar emotive examples – to name just a handful of contributory aspects.
Combining the freedom to trade at any time with our fluid view of risk is a potentially toxic cocktail. Whilst attempting to manage and control such myriad of factors is a huge challenge for all investors, it is one which should not be ignored.