In Chapter 6 of Jason Zweig's
Your Money & Your Brain, Jason explains that we don't have a defined "risk tolerance." He emphasizes several areas that effect our risk tolerance: mood, framing, how we react to percentages and herd menatality.
Studies show that the amount of risk you can take is directly correlated to your mood.
From a survival standpoint, says psychologist Amos Tversky, risk was a matter of life and death. Sensitivity to losses was more beneficial than the appreciation of gains. Over thousands of generations, a "better safe than sorry" reflex has become ingrained in humans. Various studies show, that depending on our mood, we react differently to risky situations.
Secondly, we also react to how things are framed. Researchers have demonstrated this in many ways. One classic study showed that when a four ounce glass of water has two ounces poured out , 69% of people will say the glass is half empty. If the same glass starts out empty and has two ounces poured in, 88% of people will say the glass is half full. This is a perfect example of how equivalent ways of describing something should lead to equivalent decisions. But that is not what happens.
Zweig gives many examples on where framing exists in the financial world. For example, if you put 1% of your money in a single stock that goes to zero you would be very upset. But if you lost 1% of your total portfolio you would not be as upset. You would shrug it off as a routine fluctuation.
The third factor effecting risk is how we react to percentages vs. how we react to odds expresed as frequencies. That is because percentages are abstract to people. People who are told that a surgery has a 10% failure rate react less severely to a 1 in 10 failure rate. that is because we visualize that 1 person.
Finally, Zweig explains that most of us are subject to peer pressure. People in the same office tend to invest their 401Ks in a similar manner. Even, the "smart money," supposedly independent minded investors like hedge funds, insurance companies, foundations and pension funds tend to invest in the same manner.
As in previous chapters, Zweig offers some advice to help investors manage their brain:
* Always take a time out and wait a day. remember a fight with your spouse or a good round of golf may be influencing your decision.
* Look back at history. No market continually rises. There are boom and bust cylces. When the bust comes, can you handle it?
* Reframe: if someone says the odds of success are 80%, then ask yourself if you are comfortable with a 2 out of 10 chance of loss.
* Since no one has a defined risk tolerance, think in terms of how an investment decision effects your goals, objectives, and outcomes. Have a personal investment policy statement (IPS) and stick to it.
