Perceived Risk vs Actual Risk
In this podcast, Maya and Paul Nixon, head of Behavioral Finance at Momentum, delve into the subject of perceived risk as it relates to investing, looking at issues such as how much risk you can truly afford to take in order to achieve your goals, and how your personality and attitudes about money affect your appetite for risk.
Are you aware that our ability to accurately assess risk is flawed? Think about those posters that surround the shark tanks at aquariums that compare the statistics of shark-related fatalities with those due to seemingly innocuous household items like toasters or even just falling off a chair.
Surprisingly, the numbers reveal that toasters and chairs pose a greater threat to our safety than sharks. Yet, why does the mere thought of a shark strike terror in our hearts, while a toaster fails to evoke the same dread (unless you suffer from oikophobia, the irrational fear of household appliances)?
This example illustrates the power of perceived risk: how our behaviour is governed more by what we think is risky than what the actual statistics prove.
Perceived risk can lead to behaviour tax
Perceived risk has a profound impact on our financial behaviour. Our perception of risk usually results in lower investment returns because it pushes us into trying to time markets ‒ what we call “behaviour tax”.
Sometimes investing in shares feels very risky (like during Covid) and sometimes the same shares feel very pedestrian or too safe (like in the bull market after the 2008 crisis). Acting on these feelings usually results in behaviour tax.
Luckily a good financial adviser can help us manage how we are feeling about risk by using techniques in financial psychology.
There is also the risk we can afford to take. This is a function of what we earn and what our expenses are (our personal income statement) and our ability to weather turbulent markets (which we can think of as our personal balance sheet).
For example, if we don’t have an emergency fund to draw on and there is a surprise unavoidable expense, like fixing a car or an unscheduled medical procedure, then we have a low capacity for risk. This means we cannot afford to invest in stocks because we may need to withdraw when markets are down in order to free up some cash to cover the unexpected expense.
Last but not least there is the risk we are comfortable or willing to take. This is often referred to as our tolerance for risk and should be measured psychometrically (the correct way to measure an attitude in psychology). This willingness is also connected to our personality and our attitudes about money.
In summary, when considering whether an investment is right for you, it is important to consider if it will achieve your long-term goals and indeed whether you can afford to take the risk of something negative happening in the investment (such as a temporary market downturn). Can you wait until a recovery happens?
In addition to this, consider whether you’re comfortable taking the risks of that investment. Can you sleep at night?
Finally, you should choose the right financial adviser who can help you manage the way these risks make you feel along the journey to help you stick to the plan.
Emotions and Money is a six-part podcast series in partnership with Momentum Investments, in which we unpack the psychology behind our investment decisions and how our emotions could be sabotaging our financial outcomes.