Take a better decision
RISK AND RISK TOLERANCE IN INVESTMENT DECISIONS
Published on www.psicolab.net on 20.03.2022
The decision is the ability to evaluate and choose, within a range of different options, the one that can guarantee us the best possible result.
Some decisions are easy and quick because we make them often, perhaps daily, we know the outcome, there are few variables to consider.
Others are complex. In these cases take one decision is a complex process that does not end in a single act, but takes place over a period of time and requires the contribution of cognitive and emotional skills.
The decisions regarding the allocation of savings are complex.
Faced with an investment decision, the saver must consider various factors such as: the available wealth, the time horizon, the expected return, risk and risk tolerance.
Let's consider the last two factors.
“Risk comes from not knowing what you are doing” - Warren Buffet t
"The biggest risk is not taking any risks" - Mark Zuckerberg
Warren Buffet's statement, one of the greatest investors of all time, is based on a considerable financial culture and a huge experience.
Zuckerberg's statement is based on an economic approach whereby the assumption of risk is an essential condition for the entrepreneur.
The risk relating to a financial product is directly connected to his expected return: the higher the expected return, the greater the risk.
In the financial field, risk tolerance refers to the maximum amount of fluctuation, of variability in the value of the portfolio that a saver is willing to accept and depends on multiple elements such as the level of financial culture, personality characteristics, perception of ability, the emotional state of the moment.
How can risk be assessed according to normative and descriptive theories?
In the approach to risk assessment, regulatory theories provide for the use of the Expected Value and describe the rational choice accomplished by a fully rational individual, homo oeconomicus, whose goal is the maximization of utility.
They are theories developed by mathematicians and economists.
The Expected Value is the result of a mathematical calculation: the decision maker multiplies the amount of payoffs associated with the possible outcomes of each action (for example, the return you might get or the loss you might suffer in a certain period of time for each title) for the probability that the event will occur. Eventually, it will choose the option with the highest Expected Value. There is no place in normative theories for risk tolerance.
Thanks to the studies of Bernoulli (1738), taken from von Neumann and Morgenstern (1947), a better approach to risk, from a regulatory point of view, involves the application of the Expected Utility Theory.
In the EUT the decision maker multiplies the probability of an event occurring for the utility level of the associated result. Utility is a subjective factor.
If we are risk averse, we decline a bet preferring an amount of money equal to its expected value; if we are risk-prone we accept the bet; if we are neutral then we are indifferent between the two options.
The utility function is the graphic representation of the EUT and its shape depends on the attitude towards risk, consequently each individual has a different utility function:
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Utility function
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With the Prospect Theory (PT), elaborated by the psychologists Kahneman and Tversky in 1979 we enter the context of the descriptive theories that are proposed to provide a description of how individuals actually behave when faced with a risky decision.
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Value function - source Wikipedia
Psychological factors are included in the assessment of the individual's risk attitude: status quo, frame, loss aversion, certainty effect.
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Status quo
It is the point of reference, of departure. Decision makers do not just consider utility maximization, as normative theories argue, but compare the options in relation to a subjective point of reference, that's the status quo.
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Frame
It refers to the context in which the individual finds himself making the choice
The frame, in particular the way in which the problem is formulated, affects the way in which the individual perceives the starting point, the status quo, against which to evaluate the possible outcomes of their actions.
Two identical options depending on the linguistic framing may appear in the first case a gain, in the second case a loss.
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Risk aversion in the area of gains / risk appetite in the area of losses
For most individuals, the motivation to avoid a further loss is greater than the motivation to make an additional gain (it is about 2.5 times greater). Losses are perceived as more painful than the winnings.
Here then is the risk appetite in the context of losses: we are willing to risk it all in order to avoid further painful loss.
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Certainty effect
Individuals prefer a certain event to a probable one.
When individuals have to choose from a range of options that all have positive outcomes, they tend to place greater weight on certain outcomes than the probable ones, even if these have a higher expected value.
These concepts may appear a bit obscure so, for greater clarity, I invite you, after you have done the attached test, to read the analysis relating to the content of the questions (see the links at the bottom of the page).
Well at this point let's test our risk tolerance with the “ Risk Tolerance Quiz ”.
It is in fact preferable not to invest in risky assets if our risk tolerance is minimal, to avoid to spend sleepless nights and feel regret, remorse, for the decision socket.
The test was developed, tested and published in 1999 by two university professors of Finance: John Grable and Ruth Lytton.
The Risk Tolerance Quiz was, and is, widely used by savers, financial advisors and researchers to assess willingness to engage in risky financial behavior.
NB: there are no correct and wrong answers.
The profile deriving from the answers does not represent sufficient information in itself to decide if and how to invest. Let us take advice from an experienced financial advisor.
Bibliography
Prospect Theory: An Analysis of Decision under Risk - Econometrica, 1979
Risk Tolerance Quiz - Source: Grable, JE, & Lytton, RH (1999). Financial risk tolerance revisited: The development of a risk assessment instrument. Financial Services Review, 8, 163-181.
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