Investment Risk is a Behavioural Phenomenon Not Just a Number

Risk, particularly in finance and investment, is often framed in cold and calculating terms, but such an approach can often lead us to neglect its very human features.  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”**.  How we perceive and experience risk is uniquely personal but at the same time hostage to our common behavioural limitations.

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[i].  How we feel about something tends to have an overwhelming impact on how we view the probabilities and potential outcomes.  An excellent example of this is psychologist Gerd Gigerenzer’s notion of ‘dread risk’, which he defines as a fear of low probability high consequence events.  Gigerenzer claims that a reluctance to fly following the terrorist attack in New York on September 11th 2001 meant that more Americans lost their lives on the road due to their desire to avoid flying in the following three months than died as a direct result of the horrific attacks[ii].

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. In Gigerenzer’s example, the emotional impact of the terrorist attacks were both severe and prominent in our thinking, thus the force of the potential outcome engulfed any rational assessment of probability.  Contrastingly, as we start the engine of our car and begin to drive home whilst intoxicated by alcohol are we likely to have any highly emotive examples of the potentially disastrous consequences readily in our mind?

This contradictory treatment of risk has also been evident when observing individual decision making in insurance.  Research has found that people are often underinsured against catastrophe risk – such as floods or earthquakes – even in situations where policies ae subsidized[iii].  Unsurprisingly, the likelihood that you will protect our home from disaster risk is not driven by a rational cognitive assessment of the potential costs, but by how fearful we are of the consequences, or how easily we can recall a similar situation – its availability.  If something hasn’t occurred for a long time or hasn’t recently stirred our emotions, we might simply disregard the risk entirely[iv].  The implications for investors of this type of behaviour are stark.

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.

Risk is perhaps the second most commonly used term in financial markets (second only to return). Despite its ubiquity and undoubted importance, it is often not clear what is actually being discussed.  The central debate about risk tends to be around whether it refers to volatility (how variable the price of an investment is) or the permanent loss of capital.  Quantitative strategies often rely on volatility as the central measure of risk for an asset or strategy, whereas more fundamentally driven investors will often claim that risk is the chance of losing money.  Both sides of this argument are right that their preferred measure is related to risk, but wrong to believe that there is any single concept that can encapsulate investment risk.

Let’s assume that we have two portfolios – one of 50 medium sized companies all listed on the stock market and one otherwise identical portfolio of 50 companies, but this time the companies are not listed – therefore their valuations are appraised rather than derived from public trading. Furthermore, the public portfolio can be traded on a daily basis, whereas the private portfolio is locked up for five years.  In essence we are contrasting one public equity portfolio and one private equity portfolio.  If we assume that the underlying positions are indistinguishable does this mean that the portfolios carry the same level of risk?

From a fundamental standpoint the answer must be yes – the overall outcomes will be driven by the underlying performance of the companies, but from a behavioural standpoint this is not the case.  The listed portfolio will suffer far greater price fluctuations than the private portfolio and offers the investor the ability to react to these variations (they can buy and sell); by contrast, the private equity portfolio will report smoother prices for the underlying securities, and the investor will be unable to trade – the less observable price fluctuations the less opportunity for us to react emotionally to them.  The behavioural risk (that we make bad decisions) is significantly greater in the public equity option than the private equity option.  This is by no means a validation of private equity structures, rather an example of how risk is about far more than the underlying characteristics of any asset.

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.  For example, whilst our primary risk for our investments may be a failure to build a portfolio sufficient to maintain our standard of living throughout retirement, there will be a multitude of secondary risks such as suffering from short-term losses or our portfolio underperforming relative to peers or benchmarks.   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.

We continually discuss risk solely as it pertains to a particular asset or portfolio as if it is remote from the individual experiencing it – this constitutes a glaring omission.  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.

* There is a theoretical distinction between risk and uncertainty, but they can be considered synonymous for the purposes of this post.

**This is an Elroy Dimson quote.


[i] Loewenstein, G. F., Weber, E. U., Hsee, C. K., & Welch, N. (2001). Risk as feelings. Psychological bulletin127(2), 267.

[ii] Gigerenzer, G. (2004). Dread risk, September 11, and fatal traffic accidents. Psychological science15(4), 286-287.

[iii] Kunreuther, H. (1984). Causes of underinsurance against natural disasters. Geneva Papers on Risk and Insurance, 206-220.

[iv] Kunreuther, H., & Pauly, M. (2015). Insurance decision-making for rare events: the role of emotions (No. w20886). National Bureau of Economic Research.