The concept of the “rational human” is often used in traditional financial theory. This model assumes that individuals can process information accurately and make decisions that maximize their interests. The idea seems to work in mathematical theory, but in practice, it doesn’t. When the market falls, people panic; when the market rises, they become enthusiastic.
Behavioral finance was developed to explain these seemingly contradictory phenomena. It combines psychology and economics to investigate why people make poor financial choices. Behavioral finance doesn’t assume that markets are efficient. Instead, it posits that markets are driven by human behavior, which is often flawed, biased, and contradictory.
What is Risk Perception?
In mathematics, risk is usually defined as volatility or the probability of an adverse event. It is a measurable and traceable value. People perceive risk in very different ways. Risk perception depends on an individual’s assessment of the severity and likelihood of the risk.
Two investors can look at the same portfolio and observe the same statistical volatility. One might see a tremendous opportunity for growth, while the other sees a frightening risk of failure. Regardless of the research findings, your perception is your reality. When you feel uncertain, you react as if you’re in danger, which can lead to financial actions that aren’t always necessary.
Factors That Influence People’s Perception of Risk
Many factors influence our perception of financial risk, both external and internal. Personal experience is a significant factor. Investors who start investing during a bull market are likely to be more resilient to market volatility than those who start just before a crash. The “generational effect” suggests that the economic environment you grow up in always influences your willingness to take risks.
The way we follow the news also influences how we perceive things. Financial news media often tend to sensationalize news and present normal market fluctuations as crises. When you see many negative headlines, even when the economy is doing well, your brain can start to believe a crash is imminent.
Cognitive Biases in Risk Assessment
Heuristics are mental shortcuts that help our brains process information quickly. These shortcuts helped our ancestors survive in the wilderness, but they often ruin our investment portfolios. Loss aversion is perhaps the most powerful of these biases. Studies indicate that the psychological pain associated with financial loss is almost twice as great as the satisfaction derived from an equivalent financial gain. This causes investors to irrationally avoid risks in order to escape the pain of potential losses.
Another common pitfall is the recency effect. We tend to focus more on recent events than on events from long ago. If the market has been down for three months, we assume it will continue to fall, even though history shows that markets always recover.
The Influence of Emotions on Our Risk Perception
We experience the world through our emotions. When we are anxious or agitated, even low-risk opportunities feel dangerous. Conversely, when we’re excited or pleased, risky investments seem like guaranteed profits. This is often called the “emotional heuristic,” meaning that our emotions influence our risk assessment.
Trust is also a crucial component of our emotional control. When investors trust their advisors or the financial system as a whole, they perceive less risk. As soon as this trust is broken, for example, when a company runs into trouble or changes its policy, perceived risk skyrockets, causing people to sell, even if the investment itself is sound.
How Risk Perception Influences Investment Choices
The worst consequence of a lack of understanding of risk is making the wrong choices. Those who overestimate market risk often hold their money in cash, missing out on long-term gains. They pay a high price for the sense of security they seek.
On the other hand, investors who believe risk is insignificant may take on too much risk. They might invest all their money in a risky investment because they “feel” it will be profitable, even if the probability is low. When people are afraid, they often make the mistake of buying high and selling low.
Strategies to Manage Risk Perception
To manage your perceptions, you need to develop a mechanism to prevent emotions from influencing your decisions. The best way is to stick to a diversified portfolio plan. When you invest across multiple asset classes, you don’t have to rely too heavily on a single outcome, which reduces your stress.
Automation is also a very useful tool. By setting up automatic payments, you ensure you invest on time, regardless of the market sentiment that day. Finally, a financial advisor can provide you with an objective, outside perspective. An advisor acts as a kind of emergency brake for your emotions and prevents you from making hasty decisions based on an incorrect perception of risk.
Building a Resilient Mindset
You have to manage your thoughts for your money. Investing always carries some risk, but how you assess that danger is up to you. Understanding the workings of your mind, from cognitive biases to emotional triggers, enables you to shift from emotional guidance to fact-based decision-making. Good investors don’t ignore risk; they know how to look at it.
FAQs
1. What’s the difference between the risk you’re willing to take and the risk you perceive?
Risk tolerance refers to how much capital and psychological resilience you have to cope with losses, while risk perception refers to how much risk you perceive in a given situation. You may have made a lot of money, but fear of the market may have made you inactive.
2. Does our risk perception change over time?
Yes, a person’s risk perception can change significantly. It depends on your age, your income, recent market performance, and even how you’re feeling on a given day. As people get older, they generally become less willing to take risks.
3. How does overconfidence affect your risk perception?
Overconfident investors often underestimate the chance of something going wrong. They overestimate their control over the market, leading them to view riskier options as safer.
4. Why do I feel riskier when the market goes down?
This is mainly due to herd behavior and the tendency to focus on recent events. When prices fall and the news is bad, the “danger” feels more real, causing your brain to assess a greater likelihood of loss.
5. Is it possible to completely eliminate emotional biases when investing?
Because we are human, it’s difficult to completely eliminate all emotions. However, by understanding these biases and investing according to the relevant guidelines, you can better assess their impact on your investment choices.
