When we think about risk usually we do not associate it with biology. “It’s another parameter to consider when making an Investment” – is what we tell ourselves. We tend to perceive risk as an external factor internal to the asset or portfolio we are analysing and not to us. And why is that? Why do we associate risk to an irrational set of things when its existence is solely our making?
Risk is a very hard concept to define. Some perceive it as being the unpredictability of our returns whilst others are more inclined to defining it as the loss we suffer when we don’t choose the safe bet. Whatever is the real risk definition it surely has lead to absolutely catastrophic situations. Elise Payzan-LeNestour, a behavioral scientist in the field of neurofinance, made an interesting experiment to test whether risk behavior comes from human incapability of perceiving it or human recklessness of taking it either way. In the final stages of her experiment she asked around 400 students to play a game called “The Bowman Game”. The students had to choose between two options: skip – the safe bet – or bet – the risky choice. If they chose to bet, the bowman could hit the mark, and they would win 2$, or miss it, and they would lose 40$. Also, there were two different types of bowmans: a novice – more likely to miss the mark – and an expert – more likely to hit it. After collecting all the experiment data, Elise discovered that students were actually very smart in the understanding whereas their bowman was a novice or an expert.
However, she also concluded that even when the bowman was a novice, 40% of the students took the risk of losing 40$ either way. With this, Elise was able to extrapolate to the financial market and conclude that, even though we are perfectly aware of the risks of choosing to gamble instead of the safe option, “we are greedy and lack self-control” in the sense that we evaluate those risks and still accept them when the perfectly rational choice would be to back away and choose safely.
After this discovery, Elise went deeper and associated our human need for this risky gamble to our brain functions, finding the culprit in Dopamine, a hormone triggered by potential reward opportunities.
The presence of this greed makes us put our necks on the line without backup plans or emergency exits. Taking these risks can lead to the loss of irreplaceable or non-recoverable resources, not only financially but also environmentally, for example. Our overconfidence on the market that never goes down is lost when it inevitably does and the public money goes down the drain. When we are taking part in an investment and building a continuous flow of renewable income we have to be aware of the notion of risk and of how it is not exterior to us but actually very much correlated to our reasoning and individuality. Joe Wiggins, winner of the Brian Abel-Smith Prize for outstanding performance at MSc in Behavioural Science at the London School of Economics, tells us that when we manage a set of financial assets, the risk lies as much on the asset’s trading market performance as on how frequently we check our portfolio, our individual incentives, our differences and our past experiences, to name a few. The possibility to trade at any given moment in time makes public equity investments more risky than private ones where we are less faced with price fluctuations and so have less emotional reaction. In sum, the risk of making bad decisions is lower since the immediate forces are less known. On investment, Wiggins states, “We can think of this as our erratic perception of risk continually shifting our personal discount rates”.
Risk goes beyond the convention of possible capital loss, it goes far from being only related to the asset or market characteristics, it lies much more on the human conscious action to ignore the possible (maybe less probable) consequences of losing it all. Behavioral Science & Economics alerts for the need to find tools able to deter investors from taking actions with possible “collapsing economy side-effects” because with risk “surely you will be harmed, you don’t know when, but surely you will”, says Elise Payzan-LeNestour. Investors shouldn’t continue to be rolled over for picking up nickels.