Risk Taking

To close out a positively awful month for stocks (we are on pace for the worst June since 1930!), I thought that a fitting topic would be risk. The loose definition of risk as it pertains to investors is the chance that your portfolio will perform other than expected.

As we all know, assuming more risk increases your chance of BOTH making and losing more money. Still, it has been amazing to see the types of risk to which investors continually subject themselves. I have often ended a conversation with a radio caller, thinking to myself, “I just could not sleep at night if (that were my portfolio) or (if I had that much debt).”

What makes us assume those awful risks and why aren’t human beings better at keeping themselves out of trouble? The answer to this question can be found in the fascinating field of behavioral economics. Behavioral economics applies scientific research on human and social cognitive and emotional patterns to better understand economic decisions and how they affect market prices, returns and the allocation of resources. In other words, behavioral economics combines psychology and economics.

The basis for behavioral economics is Prospect Theory, which was developed by Daniel Kahneman and Amos Tversky in 1979 (Kahneman went on to win a Nobel Prize for this and other similar work) to explain how people make trade-offs that involve risk. These two shocked economists when they challenged the notion that long-held economic view that humans made rational choices based on logical calculations.

Hang on to your hats, but here is the earth-shattering conclusion: real people are not always rational! Through a series of experiments, the two economists attempted to disprove Utility Theory, which maintains that people make trade-offs based on a straightforward calculation of the relative outcome. Some people prefer sure things and others prefer to take chances, but whether the outcome is a gain or a loss doesn't affect the mathematics and therefore shouldn't affect the results. But Kahneman and Tversky found that people have subjective values for gains and losses.

All things being equal, we tend to be risk-adverse when it comes to gains and risk-seeking when it comes to losses. In case after case, the test results proved that humans accept small gains rather than risk them for larger ones, and to risk larger losses rather than accept smaller losses.

This may be why so many investors shoot themselves in the foot when markets move to the extreme highs and lows of a cycle. And of course, Prospect Theory affects ordinary as well as professional investors. The difference is that most pros recognize this fact and abide by some system to override the natural inclination to screw up the reasoning. I have always believed that the hardest part of investing is not the analysis of the economy or even determining which assets to buy; rather it is avoiding the emotional traps into which we all fall prey --- those are the biggest challenges we face.