Risk Tolerance

In the same way that a strong magnet pulls together all the nearby pieces of metal, your level of risk tolerance pulls together all the elements of the psychology of finance. The psychological concepts are abstract; where they get real is in the day-to-day decisions that you make about buying and selling. And the common thread in all those decisions is how you feel about risk.

In the last dozen or so years, investment professionals have devoted considerable energy to helping people assess their risk tolerance. At first, it seemed like a simple task. By using interviews and questionnaires, they could construct a risk profile for each investor. The trouble is, people's tolerance for risk is founded in emotion, and that means it changes with changing circumstances. When the market declines drastically, even those with an aggressive profile will become very cautious. In a booming market, supposedly conservative investors add more stocks just as quickly as aggressive investors do.

A true picture of risk tolerance requires digging below the surface of the standard assessment questions and investigating issues driven by psychology. A few years ago, in collaboration with Dr. Justin Green of Villanova University, I developed a risk analysis tool that focuses on personality as much as on the more obvious and direct risk factors.

Summarizing our research, we found that propensity for risk taking is connected to two demographic factors: gender and age. Women are typically more cautious than men, and older people are less willing to assume risk than younger people. Looking at personality factors, we learned that the investor with a high degree of risk tolerance will be someone who sets goals and believes he or she has control of the environment and can affect its outcome. This person sees the stock market as a contingency dilemma in which information combined with rational choices will produce winning results.

For investors, the implications of behavioral finance are clear: How we decide to invest, and how we choose to manage those investments, has a great deal to do with how we think about money. Mental accounting has been suggested as a further reason people don't sell stocks that are doing badly: In their minds, the loss doesn't become real until they act on it. Another powerful connection has to do with risk. We are far more likely to take risks with found money. On a broader scale, mental accounting emphasizes one weakness of the efficient market hypothesis: It demonstrates that market values are determined not solely by the aggregated information but also by how human beings process that information.

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